Performance Aspirations and Corporate Tax Avoidance

Introduction

The issue of ethical corporate performance reporting, as a topic of interest, has been growing in both academic and the business world. While there have been vast academic debate and research on this topic, the relationship between corporate performance and corporate behavior has got vast attention among the researchers examining whether corporate performance signals an agency problem or ethical management. Based on the behavioral theory of the firm (BTOF), a theory first proposed by Cyert & March (1963) and well recognized in psychology and strategic management, it can be argued that managers’ incentive to engage in risk-taking behavior in general, and tax avoidance in particular, can be affected by whether the firms failed to achieve their aspiration level in the past.

A significant body of literature document evidence consistent with the idea that tax avoidance is related to more risk and managers’ risk preferences. For example, Rego and Wilson (2012) find a negative relationship between the CEO’s risk-taking incentives and the level of the firm’s tax avoidance measured by cash effective tax rate. There are also research findings which suggest that banks, the stock markets and regulatory bodies perceive tax avoidance as a risky activity. Hasan, Hoi, Wu & Zhang (2014) document evidence showing the existence of a positive relationship between tax avoidance and bank borrowing spreads. Tax avoiding firms are also found to incur stricter collateral and covenant requirements in bank loan contracting, face higher yield spreads when issuing public bonds, and therefore, prefer bank loans over public bonds (Hasan et al., 2014). However, a recent study by Guenther, Matsunaga & Williams (2017) and others attempt to verify whether tax avoidance is associated with greater firm risk and find that higher tax avoidance levels are more persistent than low levels of tax avoidance. This finding is consistent with the idea that higher tax avoidance reflects the extent to which firms systematically take the advantage of tax-favored legal transactions, as opposed to the managers’ incentives to reduce the firm’s tax payments through risky tax strategies. Therefore, to fill this gap in the literature, this study empirically examine a research question on the relation between firms’ aspiration level and tax avoidance.

According to the behavioral theory of the firm (BTOF), firms measure their performance, create aspiration levels based on their own past performance or that of their competitors, make a comparison between their actual performance and aspiration, and decide to make changes if the performance is lower than the aspiration level (Greve, 2003). In this study, firm’s actual performance is denoted by last year’s return on assets (ROA_t-1) and aspiration level is either historical (prior year’s return on assets/ROA_t-2 of the firm itself) or social (last year’s industry median return on assets/ROA_t-1). The difference between a firm’s actual performance and its historical or social aspiration level is the relative performance or attainment discrepancy. Performance is below aspiration if the value of attainment discrepancy is less than 0.

Using data from a sample of U.S. companies covering the period 1993 through 2016, this study presents the following compelling findings. Consistent with Kuusela, Keil & Maula (2016) which argued that firms’ performing far below aspiration prefer resource-freezing or cheaper activities such as divestment and tax avoidance than highly resource-consuming investments and Edwards et al (2016) that constrained firms are more likely to act opportunistically, this study provide evidence which support the hypothesis that firms performing below aspiration levels avoid more taxes in the subsequent period than other firms. While firms performing below aspiration are more likely to manage earnings upward (Harris & Bromiley, 2007), this study does not show that such firms also pay more taxes. The supporting corroborating tests show results consistent with the main tests. Firms which performed below their historical performance or current average peer performance tend to avoid more taxes in the subsequent year than others. This study also shows that there is no difference in the level of tax avoidance among firms performing below aspiration based on how far low their performance is compared to the aspiration level. However, for firms performing above the aspiration level, the level of tax avoidance decreases as performance gets far higher than the aspiration level.