Tax Rates and Corporate Decision Making

• In Event: Taxes and Financial Reporting

Abstract

It has long been suspected that managers use short-cuts (e.g., heuristics) to make many decisions and that their decisions are affected by behavioral biases such as a tendency to overly rely on ‘salient’ or vivid metrics/information. We document that managers do indeed rely on heuristics when they incorporate taxes into decision-making, and that tax rate salience affects their decision-making. Further, we document, for the first time in a corporate setting, that these behavioral biases lead to suboptimal decisions, and we provide estimates of the economic magnitude of the loss in firm value as a result of these biases. For example, we find that many firms employ the average tax rate paid on their income (i.e., the GAAP effective tax rate [ETR]) rather than the marginal tax rate (MTR) to evaluate incremental decisions, and that using the GAAP ETR for decision-making leads the typical firm to experience a deadweight loss of nearly $10 million for making the incorrect capital structure decisions. We also find that firms that employ the GAAP ETR for investment decision-making are less responsive to their growth opportunities and have smaller acquisition announcement returns than those using the MTR, leading to a loss in firm value of more than $20 million from suboptimal acquisitions.

Authors

• John Graham, Duke University

• Michelle Hanlon, Massachusetts Institute of Technology

• Terry J Shevlin, University of California, Irvine

• Nemit O Shroff, Massachusetts Institute of Technology