Data Truncation Bias and the Mismeasurement of Corporate Tax Avoidance

• In Event: Ongoing Research Session I

Abstract

This study examines the use of the cash effective tax rate (Cash ETR) as a measure of corporate tax avoidance. The Cash ETR normalizes cash taxes paid by pretax book income. Empirical studies of the Cash ETR delete or winsorize many observations for which the rate is not meaningful. In addition, high pretax book income in the denominator biases the Cash ETR towards the statutory rate. We propose an alternative measure that is meaningful for all observations. Our measure indicates that average book-tax differences are unfavorable to the taxpayer, whereas Cash ETR studies find the opposite. In addition, our study suggests an explanation for inconsistencies in the extant literature regarding the relation between pretax profitability and tax avoidance. Our measure shows that that more profitable firms engage in greater levels of tax avoidance.

Authors

• Erin Emily Henry, University of Connecticut

• Richard C Sansing, Dartmouth College