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TheRole of Compensation-Based
Incentives(Ⅰ)
JohnD.PhillipsUniversityofConnecticut
ABSTRACT
Thisstudyinvestigateswhethercompensatingchiefexecutiveofficersand
business-unitmanagersusingafter-taxaccounting-basedperformancemeasuresleadstolowereffectivetaxrates,theempiricalsurrogateusedfortax-planningeffectiveness.Utilizingproprietarycompensationdataobtainedinasurveyofcorporateexecutives,therelationbetweeneffectivetaxratesandafter-taxperformancemeasuresismodeledandestimatedusingatwo-stepapproachthatcorrectsfortheendogeneitybiasassociatedwithfirms'
decisionstocompensatemanagersonapre-versusafter-taxbasis.Theresultsareconsistentwiththehypothesisthatcompensatingbusiness-unitmanagers,butnotchiefexecutiveofficers,onanafter-taxbasisleadstolowereffectivetaxrates.
KEYWORDS taxplanning;
performancemeasures;
endogenoustreatmenteffects.
I.INTRODUCTION
Effectivetaxplanning,definedbyScholesetal.(2002)astaxplanningthatmaximizesthefirm'
sexpecteddiscountedafter-taxcashflows,requiresmanagerstoconsidertheirdecisions'
after-taxconsequences.Inthispaper,Iinvestigatewhetherafter-taxaccounting-basedperformancemeasuresleadtolowereffectivetaxrates(ETR),myempiricalsurrogatefortaxplanningeffectiveness.1TheETR,anincome-statement-basedoutcomemeasurecalculatedastheratiooftotalincometaxexpensetopre-taxincome,generallymeasurestheeffectivenessoftaxreductionstrategiesthatleadtohigherafter-taxincome.AlowerETR,however,canonlyproxyfortaxsavingsanddoesnotalwaysimplythatafter-taxincomeand/orcashflowshavebeenmaximized.2Despitethislimitation,theETRhasbeenusedtomeasuretheeffectivenessofspendingonthetaxfunction(Millsetal.1998)andcorporatetaxdepartmentperformance(Douglasetal.1996).Also,loweringtheETRisfrequentlycitedasawaytoincreaseearnings(e.g.,Ziegler1997)andincreaseshareprice(e.g.,Mintz1999;
Swenson1999).
Accountingresearchhasaddressedtherelationbetweenaccounting-basedcompensationandmanagers'
actions(e.g.,Larcker1983;
Healy1985;
Wallace1997).Thispaperisthefirsttoaddresswhetherafter-taxaccounting-basedperformancemeasuresmotivatemanagerstotakeactionsthathelplowertheirfirms'
ETRanddoessoatboththechiefexecutiveofficer(CEO)andbusiness-unit(SBU)managerlevels.
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Priorafter-taxperformancemeasureresearchhasfocusedonlyonthedeterminantsofcompensationCEOsusingpre-versusafter-taxearnings(e.g.,Newman1989;
CarnesandGuffey2000;
Atwoodetal.1998;
Dhaliwaletal.2000)andprovidesnoevidenceconcerningafter-taxcompensation'
seffectivenessinloweringafirm'
staxliability.ExtendingthisinvestigationtotheSBUlevelismotivatedoutoftheapparentconflictbetweenargumentsthattaxesshouldbeallocatedto SBUforincentivecompensationpurposes(e.g.,McLemore1997)withempiricalobservationsthatamajorityoffirmsdonotdoso(e.g.,Douglasetal.1996).4ThecurrentinvestigationprovidesevidenceconcerningtheincrementaleffectivenessofexplicitlymotivatingCEOsandSBUmanagerstoincorporatetaxconsequencesintotheiroperatingandinvestmentdecisions.
Acommonissueincross-sectionalstudiesthatattempttolinkaparticularmanagementaccountingchoicetoanoutcomemeasureisthatallsamplefirmsmaybeoptimizingwithrespecttothechoicebeinginvestigated(IttnerandLarcker2001).Withoutaddressingtheendogeneityofafirm'
schoice,itisdifficulttoprovideevidenceconsistentwiththischoiceleadingtoanimprovedoutcome.Toaddressthisissue,therelationbetweenETRandCEOand SBU-managerafter-taxperformancemeasuresisestimatedusingatwo-stepapproachthathelpscorrectforthepotentialendogeneitybiasassociatedwiththesetwochoicevariables.Asafirststepinimplementingthisapproach,theAntleandDemski(1988)controllabilityprincipleisusedtomodelafirm'
sdecisionstoadoptafter-taxCEOandSBU-managerperformancemeasures.Toincludeaparticularmeasureinamanager'
scompensationcontract,thisprinciplerequiresthattheexpectedbenefitsfromholdingamanagerresponsibleforameasuremustbegreaterthantheadditionalwagethatmustbepaidtocompensatethemanagerfortheresultingadditionalriskandeffort.Accordingly,anafter-taxperformancemeasureshouldbeusedasacontractingvariableinamanager'
sincentivecompensationcontractonlyifthemanager'
sinvolvementintax-planningeffortsleadstoadifferencebetweenpre-taxandafter-taxaccountingresults,whichisgenerallyreflectedintheETR.Consistentwithpriorresearch,thepre-versusafter-taxCEOandSBU-managerselecti