The effect of Earnings Quality and Internal Resource on the relationship between Tax Avoidance and Firm level Investment


Master's Thesis, 2019

55 Pages


Excerpt

TABLE OF CONTENTS

List of Tables

Abstract

Chapter 1 Introduction

Chapter 2 Literature Review
2.1. Tax Avoidance and Internal Resource
2.2. Internal Resource and Investment
2.3. Tax Avoidance and Investment
2.4. Tax Avoidance and Earnings Quality

Chapter 3 Research Design
3.1. Hypothesis
3.1.1. Relationship between Tax Avoidance and Firm Level Investment
3.1.2. The Effect of Earnings Quality on the Relationship between Tax Avoidance and Firm Level Investment
3.1.3. The Effect of Internal Resource on the Relationship between Tax Avoidance and Firm Level Investment
3.2. Model Development
3.3. Variable Measurements
3.3.1. Dependent Variable
3.3.2. Interested Variable
3.3.3. Control Variable
3.3.4. Summary of Variables and their Measurements
3.4. Sample Selection

Chapter 4 Empirical Results
4.1. Descriptive Statistics
4.1.1. Dependent Variable
4.1.2. Interested Variable
4.1.3. Control Variable
4.2. Correlations
4.3. Regression
4.3.1. Relationship between Tax Avoidance and Firm Level Investment
4.3.2. The Effect of Earnings Quality on the Relationship between Tax Avoidance and Firm Level Investment
4.3.3. The Effect of Internal Resource on the Relationship between Tax Avoidance and Firm Level Investment

Chapter 5 Conclusions

References

List of Tables

<Table 1> Summary of Variables and their Measurements

<Table 2> Sample Selection

<Table 3> Descriptive Statistics for Dependent Variable

<Table 4> Descriptive Statistics for Interested Variable

<Table 5> Descriptive Statistics for Control Variable

<Table 6>Correlation Matrix Including all Variables

<Table 7>Regression - Tax avoidance and Investment

<Table 8>Regression - Tax avoidance, Earnings Quality and Investment

<Table 9>Regression - Tax avoidance, Internal Resource and Investment

ABSTRACT

THE EFFECT OF EARNINGS QUALITY AND INTERNAL RESOURCE ON THE RELATIONSHIP BETWEEN TAX AVOIDANCE AND FIRM LEVEL INVESTMENT

Mgimwa, Cesilia Emmanuel Department of Business Administration Graduate School of Konkuk University

The perception that corporate tax avoidance represents a shift of value from the government tax authority to shareholders has been questioned by recent studies that finds this perception to not be legitimate in the data. In this study, I point out the evidence of the positive relationship between tax avoidance and firm level investment so that to provide an evidence of the managers' behavior of using savings from tax avoidance to fund firms' investment activities. Furthermore, this study, examine the effect of earnings quality and internal resource on the relationship between tax avoidance and firm level investment.

I collected data of 3085 firms from the KisValue database with accounting data for companies listed on the Korea Stock Exchange (KOSPI) from 2012 to 2017, to test the effect of earnings quality and internal resource on the relationship between tax avoidance and firm level investment. I start with year 2012 because in 2012, International Financial Reporting Standards (IFRS) adoption becomes compulsory to all listed companies in Korea. In contrast from previous research, this study looks at the relationship of tax avoidance and firm level investment from a different perspective by focusing on the effect of earnings quality and internal resource on this relationship.

The evidence of this study suggests that tax avoidance is positively associated with firm level investment. In other words, when firms increase tax avoidance, the firm level investment also increases. Adding to Dobbins and Jacob (2016) and Axel and Joachim (2017) research that found lowered tax rates, induce higher investments. This study also finds the evidence that the relationship between tax avoidance and firm level investment depends on the availability of internal resource and the level of earnings quality. The relationship between tax avoidance and firm level investment is negative when the firm has greater internal resource and better earnings quality. These results suggesting that; firms with the presence of greater internal resource (i.e. internally generated cash flow) tend to rely less on tax avoidance to fund their investment than those firms with low internal resource. Similarly, firms with better earnings quality tend to rely less on tax avoidance to finance their investment than firms with poor earnings quality.

This study makes a number of contributions. First, it contributes to the stream of literature that examines the relation between corporate tax planning and firm level investment by identifying a potential link between corporate tax avoidance and investment decisions. Additionally, this study expands the tax avoidance literature by examining the effect of earnings quality and internal resource to the relationship between tax avoidance and firm level investment.

Although this study has tried to cover all bases in the research design, I acknowledge that the results have their limitations. First, the way I measure investments could be to some extent generalizing, due to lack of access to data for some companies in the sample. Secondly, I only use two measures of tax avoidance due to lack of tax data in the sample. Finally, I acknowledge that there could be a reverse causality relation between tax avoidance and investments.

Keywords: Tax Avoidance, Investment, Earnings Quality, Internal resource, Imperfect Capital Market

Chapter 1. Introduction

Generally, tax avoidance increases the after tax cash flows, net asset and financial slack of a firm. Lisowsky, Robinson and Schmidt (2013) find that tax shelter transactions, approximately, generate federal income tax savings of $206 to $376 million. Similarly, Dyreng, Hanlon and Maydew (2008) find that tax avoidance results in substantial cash tax savings that increase a firm's after tax cash flows. The influence of taxes on corporations has largely been considered within a framework where taxes are unintentional payments that influence financing and investment choices on the margin (Desai and Dharmapala, 2006). In perfect capital market world, a firm's investment should not be related to the availability of internally generated cash flows (Modigliani and Miller, 1958). However, prior research has documented the positive and significant relationship between cash flow and firm level investment expenditure in imperfect capital markets where a firm's investment relies on internal resources.

Hubbard (1998) finds that all else being equal, investment is considerably correlated with proxies for change in internal funds and that correlation is most important for firms likely to face information related capital market imperfections. Richardson (2006) finds the evidence that over-investment is concentrated in firms with the highest levels of free cash flow. Given that tax avoidance increases after-tax cash flows and there is a positive relation between cash flows and investment (e.g. Richardson, 2006), an interesting question is whether tax avoidance is related to firm level investment and if the relationship is affected by the level of internal resource and earnings quality. Therefore, this paper investigates the effects of earnings quality and internal resource on the association between tax avoidance and firm level investment.

In perfect capital market there would be no connection between firm level investment activities and the cash flows generated internally. In this market, if a firm needed extra cash to fund investment activity it would simply raise that cash from external capital markets (Modigliani and Miller, 1958). Also if the firm has surplus cash, it would give out free cash, including cash generated from tax savings to external markets. Firms do not, however, operate in such world (Richardson, 2006). There are multiplicities of capital market frictions that obstruct the ability of management to raise cash from external capital markets. Theorists hypothesize that two capital market imperfections can lead to firms relying on internal resources to fund investment: adverse selection and moral hazard (Stein, 2003).

Adverse selection occurs when managers have greater information about the true value of the firm than shareholders. Myers and Majluf (1984) suggest that information asymmetries increase the cost of capital for firms forced to raise external finance, thereby reducing the feasible investment. Therefore in the presence of internally generated cash flow, such firms will invest more in response to the lower cost of capital which means using the internally generated cash.

Moral hazard refers to willingness of the managers to extort rents from the firm due to the dissimilarity in utility functions between managers and shareholders (Jensen and Meckling, 1976) and may lead managers to rely on internal resources because they are unwilling to expose their rent extraction to outside financiers. Moral hazard can also lead managers to overinvest, where managers make unbeneficial investments to increase the size of the firm for managers' personal gain or empire building (Jensen, 1986).

Following Lisowsky, Robinson and Schmidt (2013) and Mayberry (2012), tax avoidance increases firms' after-tax cash flows. All else equal, firms with higher levels of tax avoidance pay less (as a percentage of income) to the government tax authorities than those with lower levels of tax avoidance. Mayberry (2012) finds that firms with high level of tax avoidance use the increased after-tax cash flow to maintain a higher level of investment compared to firms with lower level of tax avoidance. A dollar kept from government taxing authorities is therefore an extra dollar of internal resource and, therefore, an additional dollar available for investment activities in the firm. Grubert (2003) finds an increase in investment of Research and Development among multinational firms that shift income to low tax jurisdictions.

In this study, firstly, I characterize tax avoidance as a firm's action of using legal loopholes to pay lower tax than other firms in the same industry. In order to measure tax avoidance, I use GAAPETR which is the difference between firm's total tax expense and firm's pre-tax income and it is the tax avoidance measure that has been used widely to capture tax avoidance activities. I also use total tax expense over operating cash flow (CFM) measure for tax avoidance (Zimmerman, 1983; Salihu, Hairul and Siti, 2013; Gebhart, 2017). The proportion of total tax expense to operating cash flow has been identified to be a better measure for tax burden of a firm (Zimmerman, 1983). Secondly, I define internal resource as the finance or capital which is generated internally by the business operations unlike external source of finances such as loan and the issuance of stocks or bonds which is externally arranged by banks or financial institutions. In order to capture the relative internal resource of a firm, I use free cash flow as a proxy for internal resource. Mayberry (2012) uses this measure to capture available internal resource in a firm.

Finally, I defined earnings quality as an ability of reported earnings (income) to forecast a firm's future earnings and how well the firm can be trusted basing on its earnings report. Specifically, it is an appraisal criterion for how consistent, convenient and bankable a firm's earnings are. Prior studies have been linking earnings quality with corporate tax avoidance (e.g. Desai and Dharmapala, 2006). With the intention of capturing the quality of earnings, I use accruals as a proxy. Desai and Dharmapala (2009) state that “In the accounting literature, a widely-used proxy for earnings quality is the use of accruals - adjustments to realized cash flows made by managers in computing the firm's net income - as these provide a measure of the extent of managerial discretion in the reporting of the firm's income”.

This study uses 3085 firm-year observations of Korean firms listed in KOSPI over the period 2012 to 2017. This final total number was obtained after I impose minimal requirements to my data. Focusing on the data, I find that, an increase in tax avoidance is positively and significantly associated with firm level investment. However, the relationship between tax avoidance and firm level investment tends to decrease when the firm's earnings quality is better. Furthermore, the relationship between tax avoidance and firm level investment is also depends on the internal resource (free cash) that the company holds. For the company with greater internal resource, the relationship between tax avoidance and firm level investment tends to slow down compared to the firms with less internal resource. These findings are consistent with the hypothesis I established.

This study makes a number of contributions. First, it contributes to the stream of literature that examines the relation between corporate tax planning and firm level investment by identifying a potential link between corporate tax avoidance and investment decisions. To the extent that tax avoidance results in substantial cash tax savings (Dyreng, Hanlon and Maydew, 2008), a manager can either misuse it or engage in value-creating and profit making activities. The results of this study suggest that a manager in a firm with greater informational transparency can use the cash savings from tax planning to make either better investment decisions. Second, this study contributes to a line of previous literature about tax avoidance, free cash flow and investment (Axel and Joachim, 2017; Mayberry, 2012) by examining the effect of tax avoidance on firm level investment when a firm relies on internally generated cash, providing the evidence to support the prior research on financial and investment policy. Third, this study contributes to the literature on earnings quality, tax avoidance and firm level investment. Additionally, this study expands the literature on tax avoidance and firm level investment by examining the effect of earnings quality and internal resource to the relationship between tax avoidance and firm level investment. Fourth, this study contributes to the corporate finance literature by providing extra vivid evidence on the capital market imperfection which links investment to internal resources (Hadlock, 1998; Richardson, 2006; Stein, 2003). Lastly, this study proposes another firm-level response for the alleviation of financing constraints which is tax avoidance adding on the literature on firms' responses to financing constraints that consider block holder ownership (Allen and Phillips, 2000), and cross-subsidies within the firm (Hadlock, Ryngaert and Thomas, 2001) as means of alleviating financing constraints.

The remainder of the paper is structured as follows. In the next chapter, I discuss literature review on internal resource, firm level investment, tax avoidance and earnings quality. In chapter 3, I describe research design while in chapter 4, I present my empirical results. Chapter 5 concludes my study.

Chapter 2. Literature Review

2.1. Tax Avoidance and Internal Resource

In general, tax avoidance activities increases the after tax cash flows, net asset and financial slack of the firm. The simple perception that corporate tax avoidance represents a transfer of value from the state to shareholders has been challenged by recent research that finds that this view does not appear to be validated in the data (Desai and Dharmapala, 2006). All else equal, firms with higher levels of tax avoidance pay less (as a percentage of income) to the tax authority than firms with lower levels of tax avoidance (Mayberry, 2012). This result in an increased after tax cash flow therefore a dollar kept from the tax authority is therefore an additional dollar of internal resource (cash flow) and, therefore, an additional dollar that may be available for financing a firm's investment activities.

There many recently studies that found a positive relation between tax avoidance and cash flow of the firm. For instance, Lisowsky, Robinson and Schmidt (2013) find that tax shelter transactions, on average, generate federal income tax savings of $206 to $376 million. Likewise, Dyreng, Hanlon and Maydew (2008) find that tax avoidance results in substantial cash tax savings that increase a firm's after tax cash flows. According to Goh, Lee, Lim and Shevlin (2013), cash savings from tax planning can be interpreted as cash flow appropriated by the firm from the tax authority, which increases expected future cash flows.

Consistent with prior studies above, tax avoidance increases internally generated cash to the firm. All else equal, managers can use that cash to expand the firm level investment.

2.2. Internal Resources and Investment

In perfect capital markets, firm's investment should not be related to the availability of internally generated cash flows (Modigliani and Miller, 1958). In perfect capital markets, managers invest resources until the marginal benefit of investment equals the marginal cost and investment is driven by investment opportunities (Hayashi, 1982; Tobin, 1969). Under this view, if firms experience a financing deficit, where investment opportunities exceed internal resources, external resources can be obtained without excessive cost (Mayberry, 2012).

However, in the real world, firms do not work in perfect capital market. The agency cost introduced by Jensen (1986) and Stulz (1990) suggests that monitoring difficulty creates the potential for management to spend internally generated cash flow on projects that are beneficial from a management perspective but costly from a shareholder perspective (the free cash flow hypothesis). Prior researches (i.e. Modigliani and Miller, 1958; Richardson, 2006) have documented the positive relation between free cash flow and investment expenditure in imperfect capital markets where a firm's investment relies on internal resources (Internally generated cash flow). Lamont (1997) and Berger and Hann (2003) find evidence consistent with cash rich segments cross-subsidizing more poorly performing segments in diversified firms. Hubbard (1998) finds that all else being equal, investment is significantly correlated with proxies for change in internal funds and that correlation is most important for firms likely to face information related capital market imperfections. Opler, Pinkowitz, Stulz and Williamson (1999) find some evidence that companies with excess cash (measured using balance sheet cash information) have higher capital expenditures, and spend more on acquisitions, even when they appear to have poor investment opportunities (as measured by Tobin's Q). Richardson (2006) finds the evidence that over-investment is concentrated in firms with the highest levels of free cash flow. Blanchard, Silanes and Shleifer (1994) find perhaps the most direct evidence on the over-investment of free cash flow. They document that eleven firms with windfall legal settlements appear to engage in wasteful investment expenditure using the excess cash flow.

Stein (2003) discusses two different capital market imperfections can lead to this positive relation between internal resources and investment: adverse selection and moral hazard. Adverse selection arises because of information asymmetry between the manager and outside financiers (Myers and Majluf, 1984; Stiglitz and Weiss, 1981). Moral hazard refers to managers' willingness to extract rents from the firm due to the difference in utility functions between managers and shareholders (Jensen and Meckling, 1976) and may lead managers to rely on internal resources because they are reluctant to expose their rent extraction to outside financiers. Moral hazard can also lead managers to overinvest, where managers make unprofitable investments to increase the size of the firm for managers' personal gain or empire building (Jensen, 1986; Richardson, 2006).

[...]

Excerpt out of 55 pages

Details

Title
The effect of Earnings Quality and Internal Resource on the relationship between Tax Avoidance and Firm level Investment
Author
Year
2019
Pages
55
Catalog Number
V537765
ISBN (eBook)
9783346133830
ISBN (Book)
9783346133847
Language
English
Tags
earnings, quality, internal, resource, firm, investment, Earningsquality, firmlevelinvestment, taxavoidance, taxavoidanceinsouthkorea, cesiliamgimwa
Quote paper
Cesilia Mgimwa (Author), 2019, The effect of Earnings Quality and Internal Resource on the relationship between Tax Avoidance and Firm level Investment, Munich, GRIN Verlag, https://www.grin.com/document/537765

Comments

  • No comments yet.
Read the ebook
Title: The effect of Earnings Quality and Internal Resource on the relationship between Tax Avoidance and Firm level Investment



Upload papers

Your term paper / thesis:

- Publication as eBook and book
- High royalties for the sales
- Completely free - with ISBN
- It only takes five minutes
- Every paper finds readers

Publish now - it's free