Shane Heitzman

A review of tax research

In this paper, we present a review of tax research. We survey four main areas of the literature: (1) the informational role of income tax expense reported for financial accounting, (2) corporate tax avoidance, (3) corporate decision-making including investment, capital structure, and organizational form, and (4) taxes and asset pricing. We summarize the research areas and questions examined to date and what we have learned or not learned from the work completed thus far. In addition, we provide our opinion as to the interesting and important issues for future research.

Leverage and Taxes: Evidence from the Real Estate Industry

Finance theory has long viewed corporate income taxes as a potentially important determinant of corporate financing decisions and capital structures. But finance academics have been unable to provide convincing empirical evidence of a material effect of taxes on corporate leverage, in part because of difficulties in constructing an effective proxy for marginal corporate tax rates, and hence for the tax benefits of debt, for large samples of individual companies. The authors address this by analyzing leverage decisions in an industry whose publicly traded entities are organized either as taxable corporations, or as real estate investment trusts (REITs) that effectively avoid entity level taxation. This enables them to measure the relative tax benefits of debt with greater precision while controlling for important nontax characteristics that affect debt usage. The tax hypothesis predicts that for real estate firms with similar asset portfolios, taxable firms should have more debt than their nontaxable counterparts. Both the nontaxable and the taxable real estate firms in our sample routinely have more than twice the leverage of industrial firms, which suggests that factors other than taxes are contributing to their use of debt. But among real estate firms, tax status appears to play a much weaker role. Taxable firms have significantly more leverage only after 2000, when restrictions on REITs were removed through new regulations that made their operations much more like those of taxable real estate firms. Our findings also depend on real estate characteristics—most notably, only residential real estate firms demonstrated differences that are consistent with the tax hypothesis. Taken together, the authors’ findings suggest that although taxes do seem to matter, their role is clearly secondary relative to factors such as the nature of the firm’s assets. A generous interpretation of our evidence puts the effect of taxes between one†third and one†half of that implied by prior research.

Net Operating Loss Carryforwards and Corporate Financial Policies

We examine the relation between tax net operating loss (NOL) carryforwards and corporate cash holdings. Corporate taxation of passive income increases the cost of holding liquid assets (“cash†), but NOLs can shield that income from tax. We test whether NOLs are associated with greater levels of cash. We develop a new proxy for worldwide NOL benefits from footnote disclosures that more precisely captures their worldwide value and demonstrate our proxy’s superiority over common alternatives. Our empirical evidence suggests that NOLs lead to greater cash holdings, mitigate the impact of repatriation taxes on cash holdings, and increase investor valuation of cash. Our paper provides new evidence of how corporate financial policies respond to taxation, considers interactions with other tax explanations, and demonstrates the value of proper NOL measurement.

Corporate Tax Planning and Stock Returns

We investigate whether industry tax planning affects a firm’s cost of capital by increasing its exposure to tax policy risk. We find evidence that equity returns increase with the propensity for tax planning in a firm’s industry. Consistent with a policy risk interpretation, the magnitude of the identified premium becomes stronger during periods of high Democratic influence over the White House and the United States Tax Court. This risk premium is imposed on all firms in the industry, even those that are less aggressive than their industry peers, which is consistent with the existence of an industry-wide externality. The industry-based risk premium coexists with a firm-specific risk discount associated with active tax planning strategies with low systematic risk. This individual firm effect, however, is dwarfed by the industry-based risk premium and is concentrated in industries that are less likely to attract scrutiny from the tax authority.

Internal Information Quality and Investment Sensitivities to Market Value and Cash Flow

A growing literature shows how external information quality affects investment responses to market value and cash flow—frequently used proxies for investment opportunities and internal funds. However, such associations are also shaped by internal information quality. We predict that investment is more sensitive to internal cash flow signals and less sensitive to external market value signals when managers have higher quality internal information. In line with recent theoretical and empirical research, we proxy for internal information quality using observable information properties. We find that the sensitivity of investment to cash flow is increasing while the sensitivity of investment to market-to-book is decreasing in information quality. This evidence is consistent with internal information-based predictions and inconsistent with external information-based explanations. Our results offer a new and unique insight robust to several alternative explanations and hold up using recently-developed techniques to correct for measurement error in market valuations.A growing literature asserts that the quality of external reporting affects investment responses to market value and cash flow—frequently used proxies for investment opportunities and internal funds. However, such associations are also shaped by the quality of internal information. We predict that investment is more sensitive to internal profit signals and less sensitive to external market value signals when managers have higher quality internal information. In line with recent theoretical and empirical research, we proxy for internal information quality using observable information properties. We find that the sensitivity of investment to profitability is increasing, while the sensitivity of investment to market-to-book is decreasing in internal information quality. This evidence is consistent with internal information-based predictions and inconsistent with external reporting-based explanations. Our results offer new and unique insights robust to several alternative explanations and hold up using recently developed techniques to correct for measurement error in market valuations.