home / study / questions and answers / business / accounting / the study of taxa
ID: 2498385 • Letter: H
Question
home / study / questions and answers / business / accounting / the study of taxation has an impact on decision-making ... Your question has been answered! Rate it below. Let us know if you got a helpful answer. Question The study of taxation has an impact on decision-making and individual behavior, business activity, and society in general. Recognition of tax issues and their relationship between the financial decision making process is integral for a manager to understand. How do managers apply these theories written in 1000 words
Explanation / Answer
Taxes represent a substantial cost for most profitable corporations and, thus, are an important input into many corporate decisions. According to theory, the marginal tax rate (MTR), defined as the present value of additional taxes paid on an additional dollar of income earned today is the appropriate rate to use to evaluate incremental corporate decisions (Consistent with this theory, prior research finds that the MTR is correlated with firms’ capital structure decisions (e.g., Graham, 1996a; Heider and Ljungqvist, 2014). However, prior research also finds that firms often have conservative debt policies given their MTRs (e.g., Graham, 2000; Strebulaev and Yang, 2013), raising the question of whether managers do indeed incorporate the MTR in incremental leverage decisions or whether the MTR is simply correlated with the tax rate they use.
Companies consider tax rates in generally the following decisions: (i) mergers and acquisitions (M&A), (ii) capital structure, (iii) capital investment, (iv) purchase versus lease, (v) cost of capital computations, (vi) where to locate new facilities, and (vii) compensation. These rates either are the U.S. statutory tax rate (STR) or the ‘average’ tax rate computed in financial statements (the GAAP effective tax rate [GAAP ETR], defined as income tax expense scaled by pretax book income, both financial accounting numbers) for evaluating incremental decisions. Although these findings are seemingly inconsistent with corporate finance theory, they are potentially consistent with the theories and evidence in psychology and behavioral economics, which have focused primarily on consumers/individuals in non-corporate settings (DellaVigna, 2009). For example, prior research finds that (i) individuals (and managers in some cases) use simple heuristics in many decision-making contexts rather than more complex (and fully rational) approaches (e.g., Tversky and Kahneman, 1974; Simon, 1979; Gabaix, Laibson, Moloche, and Weinberg, 2006) and (ii) individuals are affected by tax rate salience (e.g., de Bartolome, 1995; Finkelstein, 2009; Chetty, Looney, and Kroft, 2009). Computing the MTR is complicated due to unique features of the tax code (e.g., the treatment of net operating losses, alternative minimum tax, etc.) coupled with the need to forecast taxable income many years into the future. It is precisely in such complicated situations that managers are likely to make decisions based on heuristics such as the STR, which is well-known to all firms and readily available. Similarly, for publicly traded companies, the GAAP ETR is easily computed using financial statement data, and is indeed the focus of much managerial attention. Exploring each of these issues in detail it is found that the difference between the STR and the MTR is less than two percentage points for the majority of firms that use the STR as the tax rate input for decision making. This suggests that when a firm uses the STR, in many cases the STR closely approximates the MTR, consistent with the STR being a simple heuristic employed by managers. Public firms (relative to private firms) and firms with high analyst following (relative to firms with low analyst following) are more likely to use the GAAP ETR as the tax rate in their decisions, consistent with the idea that capital market pressure increases the salience of the GAAP ETR and thus increases its usage in decision-making. Finally, larger firms (conditional on being public), high R&D intensity firms, and high institutional ownership firms are more (less) likely to use the MTR (ETR) for decision making, consistent with sophisticated firms and firms with greater external monitoring (i.e., institutional ownership) more correctly incorporating taxes into their decision making. While the MTR is the theoretically preferred tax rate to evaluate the tax impact of incremental decisions, and the STR is equivalent to the MTR for highly profitable firms without NOLs and thus qualifies as an efficient heuristic, there is very little justification (at least in theory) for using an average rate such as the GAAP ETR as the tax rate input for decision-
The effect of tax policy on corporate behavior. Governments use tax policy to provide incentives and disincentives for certain actions (e.g., investment) and thus the degree to which taxes actually impact corporate decisions determines whether such policies are effective. Standard economic models assume that firms respond to changes in their MTR by making the right connection between their income and tax schedule. As a result, the effects of tax changes predicted by standard economic models are likely to be different when managers base decisions on an average tax rate such as the GAAP ETR rather than the MTR.
When making a location specific decision, generally the majority of managers use jurisdiction specific rates (statutory and effective) as the tax rate input for decision making.
Determinants of managers’ tax rate choice managers’ tax rate choices are affected by the following: (i) the complexity of calculating the tax rate and the availability of simple 16 heuristics that (are equal to or) approximate the expected tax costs, (ii) the salience of different tax rates to managers, (iii) the likely availability of tax planning opportunities, and (iv) the existence of governance mechanisms to monitor managers. These factors do not comprise a complete list of all the factors that affect managerial tax rate choices.
Tax planning opportunities: Firms with greater tax planning opportunities are more likely to be tax savvy and hire well-trained tax personnel because they can derive greater benefits from the tax planning. Prior research finds evidence that individuals often use average tax rates instead of marginal tax rates when faced with marginal investment choices.
Tax rate choices and their economic consequences : whether using the GAAP ETR as the tax rate input leads to inefficient corporate decisions2. Capital investment consequences: Firms that use the GAAP ETR as the tax rate input for capital investment decisions make inefficient capital investment decisions. The intuition is that differences between the MTR and GAAP ETR can lead firms to incorrectly forecast the after-tax cash flows from their current and potential investments. Incorrect cash flow forecasts are likely to create biases in firms’ evaluation of their existing investments’ NPV as well as that of their investment opportunities, leading to too little investment in high NPV projects and/or too much investment in low (or negative) NPV projects, and thus leading to a weaker relation between investment and investment opportunities (i.e., inefficient decisions).
Finally, firms that use the GAAP ETR as the tax rate input for M&A decisions are more prone to making value-decreasing acquisitions. Acquisitions are among the largest and most readily observable forms of corporate investment and thus an important corporate decision with a significant effect on firm value. Typically, acquisition decisions require rigorous due diligence that includes evaluating the target firm’s value as a stand-alone business and the value of potential synergies gained from combining businesses. Both processes require firms to forecast after-tax cash flows. To the extent that firms use the GAAP ETR to measure the tax impact of the acquisition decisions, they are likely to under- or over-estimate the value of the acquisition. Underestimating the expected value created from an acquisition is likely to result in the firm simply not engaging in the acquisition or being outbid by competing bidders. On the other hand, conditional on completing an acquisition, companies using the GAAP ETR as their tax rate input for decision making are more likely to have either overbid for the target and/or more likely to have made other errors in forecasting the value of the acquisition (e.g., the value of the target’s NOLs). Thus, companies that use the GAAP ETR for decision making are more likely to make value destroying acquisitions, especially when the GAAP ETR is different from the MTR
Finally, following conclusions can be made that though the difference between the statutory tax rate (STR) and MTR is less than two percentage points for the majority of the firms using the STR as the tax rate input for decision making. Thus managers rely on simple heuristics that approximate theoretically correct constructs in their decision making process. Companies that are more focused on external reporting (e.g., public firms and firms with high analyst following) are significantly more likely to use the GAAP ETR as the tax rate in their decisions. In contrast, firms less focused on external 40 reporting (e.g., private firms) are significantly more likely to use STRs as the tax rate in their decisions. These results suggest that managers have a salience bias with respect to the tax rate used for decision-making. Finally, larger firms (conditional on being public), firms with high R&D intensity and high institutional ownership are more likely to use the MTR for decision making, suggesting that firms with greater tax planning opportunities and more external monitoring effectively incorporate taxes into their decision making.. Firms using GAAP ETRs as the tax rate input for their capital structure decisions adopt an aggressive (conservative) debt policy when their GAAP ETR is greater (less) than their MTR. In terms of investment outcomes, firms that use the GAAP ETR as the tax rate input for investment decisions are less responsive to their investment opportunities and have lower acquisition announcement returns when the difference between their firm’s MTR and GAAP ETR is large. These results suggest that the tax rate firms use to incorporate taxes into their business decisions has important economic consequences. Specifically, the use of GAAP ETRs instead of the theoretically suggested MTR as the tax input for decision making leads to inefficient corporate decisions
(Bibliography : Michelle Hanlon “Tax rates and Corporate decision making ,John R Graham “tax rates and Corporate decision making”.)
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.