Tax Avoidance, Tax Aggressiveness, Tax Risk and Firm Risk

David A. Guenther, Steven R. Matsunaga*, Brian M. Williams

Lundquist College of Business, University of Oregon, Eugene, OR 97403 USA

August 2013

Abstract: In this study we distinguish between the concepts of tax avoidance, tax
aggressiveness, and tax risk and examine which, if any, of those concepts is related to overall
firm risk. Prior research has argued that aggressive corporate tax avoidance, as measured by low
cash effective tax rates or high reserves for unrecognized tax benefits, increases firm risk,
thereby requiring firms to provide risk-taking incentives to managers. In this paper we define the
concept of tax risk as the ability of a firm to sustain its tax positions over time and test whether
tax avoidance, tax aggressiveness, or tax risk are related to future stock return volatility. We find
a significantly positive relation between tax risk and firm risk, but do not find evidence of a
significant association between either tax avoidance or tax aggressiveness and firm risk.

JEL classification: M41

Key Words: effective tax rates; unrecorded tax benefit; tax aggressiveness; tax risk
*Corresponding author:
Professor Steve Matsunaga
Lundquist College of Business
1208 University of Oregon
Eugene, OR 97403-1208
Phone: (541) 346-3340
Fax:
(541) 346-3341
email: stevem@uoregon.edu
We thank Kathleen Powers and the rest of the Texas Tax Reading Group, the Iowa Tax Reading
Group, Jenny Brown and the rest of the Arizona State Tax Reading Group, Michelle Hutchins,
Sonja Rego, Carlos Jimnez-Angueira and workshop participants at the University of Oregon,
the 2013 AAA Western Regional Meeting and the 2013 AAA Annual Meeting for helpful
comments. Support from the Finance and Securities Analysis Center at the Lundquist College of
Business is gratefully acknowledged.

Tax Avoidance, Tax Aggressiveness, Tax Risk and Firm Risk

1. Introduction
Surveys and other publications by tax practitioners have focused attention on the notion
of "tax risk" as a type of business risk that must be managed by public corporations.1 Tax risk
and its effect on public companies has also been the subject of academic research in accounting.
Since tax risk is by definition "risky," it has been argued that firms must provide risk-taking
incentives for managers to encourage them to undertake risky value-maximizing strategies that
reduce the firms tax payments (Brown, Drake, and Martin 2013; Rego and Wilson 2012; Boivie
et al 2012; Higgins, Omer and Phillips 2012; and Robinson, Xue, and Zhang 2012). Despite the
view that reducing corporate taxes is risky, there is a lack of empirical evidence linking taxreduction activities to an increase in firm risk.2
Managers adopt a wide range of tax policies designed to reduce firms corporate tax
payments, and researchers are not always consistent in either the terms used to describe these
policies, or the empirical measures used to identify them. Our goal in this study is to differentiate
between three different concepts that characterize tax policywhich we refer to as tax
avoidance, tax aggressiveness, and tax riskand to propose appropriate empirical measures for
each concept.3 We then investigate whether any, or all, of the empirical measures are associated
with a well-accepted measure of firm risk: future stock return volatility.4 Our purpose is to
provide insight into how firms tax policies affect the overall risk of the firm.

See for example Ernst & Young (2011), KPMG (2011), and PricewaterhouseCoopers (2004).
In work that is somewhat related to our question, McGuire, Neuman and Omer (2013) examine how the
persistence of tax avoidance strategies affects earnings persistence, and Campbell, Chen, Dhaliwal, Lu, and Steele
(2013) examine how corporate effective tax rates are related to managers' discussion of tax risk in 10-Ks.
3
Our classification of three different concepts of tax policy is similar to the classification used in Lisowsky,
Robinson and Schmidt (2013).
4
We focus on the traditional view of firm risk as being reflected in the volatility of stock returns, since this is the
type of risk for which managers are compensated by the use of employee stock options.
2

In finance the term "risk" is generally used to describe the spread or dispersion of
possible outcomes or payoffs from an investment, reflecting the degree of uncertainty about the
future (Brealey and Myers 1991 p 114). Neuman, Omer and Schmidt (2013, 6) relate this
concept to corporate tax risk, stating: "Tax risk refers to the potential that a chosen action or
activity [...] will lead to a tax outcome that is different than initially expected." The simplest and
most commonly used measures of spread or dispersion are the standard deviation and variance of
the payoffs (Powers 2009). These have been the traditional measures of risk in academic finance
research for some time (e.g., Markowitz 1952) and continue to be used in current research (e.g.,
Cassel, Huang, Sancez, and Stuart 2012). Measuring risk as the variance or standard deviation of
expected outcomes or payoffs is also a standard approach in finance textbooks (e.g., Fama 1976;
Cochrane 2001; Pennacchi 2007).
To investigate the relation between a firms tax policies and firm risk, we consider three
underlying concepts that have been used to characterize firms tax policies. The first concept is
tax avoidance, which we define as adopting tax policies that reduce the firms income tax
payments. Following Dyreng, Hanlon, and Maydew (2008) we use the Cash ETR as the
appropriate measure of tax avoidance. Dyreng et al. (2008) describe a low Cash ETR as the
ability to pay a low amount of cash taxes per dollar of pre-tax earnings over long time periods."
Tax policies that avoid more taxes, and lead to lower Cash ETRs, could increase the firms risk if
the underlying activities that allow the firm to lower tax rates are inherently risky, or if lower tax
rates are less sustainable than higher tax rates. On the other hand, the ability to avoid taxes has
been shown to be stable over long time periods (Dyreng et al. 2008). In this case, the firms tax
rate would be fairly stable over time, and the riskiness of the underlying activities may not be

different from similar more highly taxed investments, in which case tax avoidance activities
would not be associated with firm risk.
The second tax policy concept we examine is tax aggressiveness, which we define as the
extent to which the firm takes tax positions that are unlikely to survive a challenge by the I.R.S.
Tax avoidance differs from tax aggressiveness in that firms can lower their tax rates while still
taking tax positions that are unlikely to be overturned by the I.R.S. For example, opening a
subsidiary in a low tax country, taking advantage of accelerated depreciation deductions, or
qualifying for research and development tax credits would allow a firm to avoid paying income
tax in ways that would generally not be challenged by the I.R.S. and therefore would not
represent tax positions that are aggressive. On the other hand, if firms reduce their tax payments
by engaging in activities or interpreting the tax code in ways that would be unlikely to be upheld
if the firm were audited, they are exhibiting tax aggressiveness.
The empirical measure that appears to best capture the concept of tax aggressiveness is
the reserve for Unrecognized Tax Benefits (UTBs) as defined by FASB Interpretation No. 48
(FIN 48). FIN 48 was specifically created to limit the ability of firms to reduce their reported tax
expense by taking positions that are unlikely to be upheld in the future. Tax aggressive policies,
reflected in a high UTB reserve, could increase firm risk if there is a high degree of uncertainty
with regard to future tax payments. However, despite the name, it isnt clear whether UTB
reserves actually reflect uncertainty about a firms future tax payments. Consistent policies
whereby new aggressive positions offset settlements could lead to fairly predictable tax
payments. In addition, the resolution of uncertain positions could take years to work through the
judicial system. Finally, the determination of the UTB reserve is subjective and is therefore

subject to the biases inherent in the accrual process. We therefore view the effect of UTBs on
firm risk as an empirical question.
The third tax policy concept we examine is tax risk, which we define as uncertainty
regarding the firms future tax payments. Tax risk differs from tax avoidance and tax
aggressiveness in that it reflects the extent to which a firm is able to sustain its tax positions over
time. A firms tax payments are likely to change over time for a variety of reasons, including
changes in domestic and international tax law, the extent to which aggressive tax positions are
settled for or against the firm, or the firms ability to maintain tax-favored investments.
Regardless of the source, variability in the firms tax rate should be reflected in uncertainty about
the tax rate investors should apply to pretax income or cash flows in assessing the firms future
after-tax cash flows. We use the standard deviation of the firms annual cash ETR to measure tax
risk.
As noted above, recent and concurrent research assumes or asserts that policies that
reduce the firms tax payments are "risky." In other words, one of the economic consequences
managers need to consider in determining the firm's tax policies is the impact on firm risk. This
view leads to the conclusion that managers consider a trade-off of the benefit from increased
cash flows from reduced tax payments against the cost of increased firm risk. To provide
empirical evidence on this issue we estimate the relations between firm risk (the one year ahead
volatility of the firms stock return) and three measures of tax policy: (1) the level of tax
avoidance (the cash effective tax rate), (2) tax aggressiveness (the reserve for UTBs), and (3) tax
risk (the standard deviation of the annual Cash ETR).

Before conducting our main tests, we first examine how each of the three tax policy
characteristics is related to the others.5 As expected, we find that the Cash ETR is negatively
correlated with the UTB reserve, which suggests that firms that take aggressive tax positions pay
lower amounts of their pretax income in taxes. However, perhaps surprisingly, we find a positive
correlation between the Cash ETR and tax risk, and a negative correlation between the UTB
balance and tax risk. These results suggest that firms that take aggressive tax positions and are
able to reduce their tax payments experience relatively stable tax rates.
We also examine the characteristics of firms that have high levels of tax avoidance, tax
aggressiveness, or tax risk. We find substantial differences in firm characteristics between firms
that demonstrate high tax avoidance or tax aggressiveness and firms that have high levels of tax
risk. Together, these results suggest that although the three concepts, or measures, are related,
they seem to capture different aspects of a firms tax policies.
In our main tests we regress future stock return volatility against each of our tax policy
measures. As discussed by Neuman et al. (2013), tax risk is an ex ante concept, and reflects
expected uncertainty about future events, so our measure of firm risk captures future volatility.
Our tests control for factors that prior research has linked to future stock return volatility,
including the historical variance of pretax earnings. We find that our measure of tax riskthe
standard deviation of the annual Cash ETR, measured over a five-year periodis positively
related to future stock return volatility. This result holds for both the full sample and the more
limited UTB sample, and is consistent with tax risk increasing the uncertainty of after-tax cash
flows. On the other hand, we do not find significant associations between future stock return
volatility and either the level of Cash ETR or the level of the UTB reserve. These results suggest
5

Because the UTB reserve is not available until 2007 or 2008, we conduct our tests on two samples. For tests that
do not require UTB data we use the full sample from 1987 2011. Tests that include the UTB reserve are conducted
on a more limited sample for which UTB data are available.

that tax avoidance and tax aggressiveness do not increase overall firm risk, and suggest that such
activities may not be risky in the traditional sense of that term.6, 7
We also investigate possible reasons why firm risk appears to be unrelated to either tax
avoidance or tax aggressiveness. One reason may be that these tax policies are only related to
firm risk when firms use the policies to unusually high degrees. To test this explanation, we
define indicator variables for each of our tax policy measures that identify observations in the
lowest quintile of Cash ETR or highest quintile of the UTB reserve or standard deviation of the
Cash ETR. Results using these extreme values are similar to our initial results in that firms with
high tax risk (i.e., high standard deviation of Cash ETR) have significantly higher firm risk, but
firms with high tax avoidance or tax aggressiveness do not have higher firm risk.
Our study makes several contributions to the literature on accounting for income taxes.
First, we clarify the underlying concepts reflected in different tax policies by differentiating the
concepts of tax avoidance, tax aggressiveness, and tax risk and suggesting appropriate empirical
measures to capture each type of tax policy. We also document systematic differences between
the characteristics of firms that display differences in tax avoidance, tax aggressiveness and tax
risk, which helps provide insight into which types of tax policies are captured by each measure.
Our results also highlight the importance of carefully considering which empirical measure best
reflects the underlying construct being studied.
We also provide evidence regarding the impact of different tax policies on firm risk. A
number of recent studies examining the determinants and economic implications of tax policies

If low Cash ETRs proxy for risky tax positions, we expect this risk to be reflected in stock returns in a future year
when additional tax and penalties are paid. For consistency, we use the same twelve-month period to measure stock
return volatility for all three of our tax aggressiveness measures.
7
In a concurrent paper, Hutchins and Rego (2012) document a significantly positive relation between the UTB
reserve and concurrent stock volatility. However, their empirical model does not include many of the control
variables from our study that prior research in finance has documented to be related to stock volatility.

have implicitly or explicitly assumed that tax avoidance and/or tax aggressiveness are risky
activities. We do not find evidence that investments in tax avoidance, as measured by the Cash
ETR, or tax aggressive policies, as measured by the UTB reserve, increase the firms overall
risk. In contrast, we document evidence that uncertainty with regard to the firms Cash ETR, as
measured by the standard deviation of the Cash ETR, is positively associated with firm risk. Our
results are consistent with the notion that when the volatility of cash ETR is high, investors have
more uncertainty regarding the tax rate applicable to the firms pretax cash flows. As information
is released that resolves that uncertainty, the stock price adjusts, thereby increasing stock return
volatility. Overall, our results suggest that tax policies that reduce the firms tax payments, or
increase the firms UTB reserve, only increase the risk of the firm if they increase uncertainty
regarding the firms tax future tax payments, suggesting that the firm is unable to sustain those
positions over time.

2. Tax Policies and Firm Risk

A key concept regarding a firms tax policies is tax avoidance, which represents the
ability of the firm to reduce its current tax payments. Tax avoidance is generally measured as the
ratio of taxes paid during the year to pretax financial reporting income: the Cash ETR. The
measure can be calculated on an annual basis, although Dyreng et al. (2008) recommend using
the sum of taxes paid over a five-year period and the sum of pretax income over the same period
to provide a better picture of the firms tax policies. Studies such as Brown, Drake, and Martin
(2013), Rego and Wilson (2012), Boivie et al (2012), and Higgins, Omer and Phillips (2012)
suggest that aggressive tax planning is a risky activity. They argue that firms lower their tax
payments by taking tax positions that have a relatively high probability of being disallowed.

Thus, although investments and policies that reduce the firms tax payments have a positive
expected value, the possibility that the firms tax positions will be challenged by the I.R.S. and
overturned by the courts makes these tax policies risky. Therefore, to encourage managers to
take risky tax positions with a positive expected value, the compensation committee increases the
reliance on stock options in executive compensation packages. This is consistent with the results
in Rego and Wilson (2012), who document a negative relation between the CEOs risk-taking
incentives (the vega of their equity portfolio) and the level of a firms cash ETR.8
However, it is not clear that investments that generate lower tax payments will lead to
more volatile future cash flows and stock returns. Multinational companies generate a substantial
amount of their income in countries with low tax rates. As long as these companies reinvest their
operating earnings outside of the U.S., the corporation will continue to avoid the higher U.S. tax.
If a firm maintains a low, stable tax rate it is unlikely that the firms tax policies induce volatility
in the firms cash flows or stock returns. As an example, Panel A of Appendix A presents the
Cash ETR and volatility of Cash ETR for IBM from 2003 to 2007. IBM was consistently able to
pay a relatively low amount of taxes with a Cash ETR of 16.10%. The standard deviation of the
annual Cash ETR over this period was a relatively low 0.11. Thus, while the tax policies of IBM
appear to have lowered the taxes paid, the company was able to maintain that low rate fairly
consistently over the five-year period.
A second characteristic of tax policies is tax aggressiveness, or the extent to which firms
use ambiguity in the tax law to reduce their tax payments. For example, a firm may decide that
there is no clear authority on the tax treatment applicable to a specific transaction and assesses
the probability that a favorable interpretation has a 10% chance of being supported based on its
8

Armstrong, Blouin, and Larcker (2012) do not find a significant relation between the reliance on incentive-based
compensation (compensation mix) for the CEO and the firms Cash ETR. Thus, their evidence suggests that the
provision of stronger incentives to the CEO does not affect the firms tax policies.

technical merits. A tax aggressive firm would choose the favorable interpretation in preparing its
tax return, thereby reducing its current tax payments. We argue that the appropriate measure for
tax aggressiveness is the firms UTB reserve. FIN 48 requires firms to establish a reserve for a
tax position if it is more likely than not that the position will not be upheld based on its technical
merits. Thus, by definition, the UTB reserve should reflect the extent to which firms take tax
positions that are aggressive in the sense that they may not be in accordance with the tax law.
As an example, in its 2012 10-K Microsoft reported a UTB reserve of $7.2 billion and noted that
the primary unresolved issue relates to transfer pricing, which could have a significant impact
on our financial statements if not resolved favorably.
Taking aggressive tax positions can be considered a risky activity since it is likely that
their positions will be overturned in the future and the firm could have to repay the tax plus
interest and penalties. However, the impact of aggressive tax policies on overall firm risk is not
clear. First, the determination of whether a given tax position should be included in the reserve
requires subjective judgment. As a result, different firms taking the same tax positions are likely
to have different UTB reserves. Second, the time period in which the tax positions will be
resolved is not clear. Microsoft states that we do not believe the remaining open issues will be
resolved within the next 12 months. Thus, the impact of aggressive tax positions on the firms
tax payments could be delayed for an indefinite period of time. In fact, because Fin 48 specifies
that firms ignore the probability of audit, it is possible that the amounts in the UTB reserve will
never be paid. Finally, if firms consistently take aggressive tax positions, unfavorable resolutions
of prior aggressive tax positions could be offset by new aggressive tax positions, leaving the
firms total tax payments relatively constant over time.

The third characteristic of tax policies we consider is tax risk, which we define as
uncertainty about the firms tax rate. We measure tax risk as the standard deviation of a firms
Cash ETR, which captures the volatility of the Cash ETR.9 Our measure of tax risk essentially
measures the extent to which a firm is able to sustain its tax positions over time.
As an example, consider the case of DPL Incorporated, detailed in Panel B of Appendix
A. Over the 2002-2006 period the standard deviation of the companys cash ETR is 0.23, which
places it in the top quintile of the distribution. . DPLs annual cash ETR dropped from 75.58% in
2002 to 6.03% in 2003, and rose to 31.47% in 2004. The volatility in the Cash ETR for DPL
suggests the company was unable to sustain the tax positions that lowered the Cash ETR in 2003.
As a result, at the end of 2006, there is uncertainty whether the firm will pay a tax rate close to
the 42.64% paid in 2006, drop to the 26.79% paid in 2005, or rise back to the 75.58% paid in
2002. Therefore, after forecasting pretax income, investors face additional uncertainty in
determining the appropriate tax rate to use to forecast after-tax cash flows. While in the case of
IBM, information released in the subsequent year regarding IBMs actual tax rate is likely to
have a relatively small effect on IBMs after-tax cash flows and share price, information
regarding whether DPL will be paying 75.58 percent of its pretax income or 6 percent of its
pretax income in taxes will have a relatively large effect on after-tax cash flows and thereby lead
to a higher volatility in stock returns.
While it may seem obvious that uncertainty about a firm's tax rate will affect overall firm
risk, we believe there are two reasons why the relation between tax risk and firm risk is an
empirical question. First, to the best of our knowledge there is no prior empirical evidence that
uncertainty regarding a firms tax rate leads to uncertainty with regard to the firms after-tax cash

As we discuss below, we also conduct a sensitivity test using the coefficient of variation of the Cash ETR, which
scales the standard deviation by the mean. Our results are similar with either measure of volatility.

10

flows. Second, despite publications by practitioners stating that tax risk is a component of firm
risk, it may be the case that investors do not consider corporate taxes when making investment
decisions, and in that case stock return volatility would be unrelated to tax rate volatility.
In a concurrent paper, Hutchins and Rego (2012) examine how different measures of tax
risk relate to the firms cost of capital. The cost of capital can be interpreted as a measure of the
risk perceived by shareholders. However, the theoretical link between tax risk and the firms cost
of capital is not clear, since tax risk is a type of idiosyncratic risk which investors can avoid by
diversification. In addition, empirical measures of cost of capital relate current stock price to
analysts' earnings forecasts. This is problematic because the UTB reserve, a measure of tax risk,
reflects tax benefits that have, by definition, not been recorded in the firm's earnings. In other
words, if the risky uncertain tax benefits are not reflected in the analysts' forecast of earnings, it
isn't clear why a higher discount rate should be applied to those forecasted earnings to arrive at a
stock price. In contrast, the measure of firm risk we use in this paper, stock return volatility, is a
more direct, albeit ex post, measure of the underlying uncertainty regarding the firms after-tax
cash flows.10 Stock return volatility also has a direct influence on the value of risk incentives in
that option-pricing models show that the value of a stock option increases with stock return
volatility.

3. Empirical Tests
3.1 Sample Selection and Key Variable Definitions
Our sample begins with all observations on the CRSP/Compustat merged database from
1987 to 2011 with data necessary to compute our regression variables. We start with 1987

10

In other words, a firm with volatile after-tax cash flows will have volatile stock returns, regardless of the effect of
tax risk on cost of capital.

11

because this is the first year that many of the data items necessary to compute our variables of
interest, such as cash taxes paid, are available on Compustat. To reduce the impact of different
legal systems, including tax laws and enforcement, we drop firms that are not incorporated in the
U. S. To allow a meaningful interpretation of the Cash ETR we require firms to have positive
pre-tax income (Dyreng, et al. 2008). In addition, each firm must have sufficient data for five
consecutive years to calculate the Cash ETR, and data for a sixth consecutive year to calculate
stock return volatility. Finally, we require firms to have stock return data for all 12 months of the
year on the CRSP database. This procedure yields a total of 16,547 firm-year observations.
Table 1 shows the number of times each unique firm appears in our sample. Because we
use firm fixed effects in our analyses utilizing our full sample, we require each firm to appear at
least twice in our sample. Our sample includes of 2,376 unique firms, with 388 firms appearing
twice and a total of 69 firms appearing the maximum of 19 or 20 years.11 The vast majority of
firms in our sample are not present throughout the entire sample period, due to both sample
changes (firms that exit before the end of the sample period or enter after the beginning of the
sample period), and the requirement that the firm have positive pre-tax income for five
consecutive years. To control for the fact that we have multiple and unequal numbers of
observations per firm and per year in our sample, we include both firm and year fixed effects in
the regressions.
Following Dyreng et al. (2008), we calculate our measure of tax avoidance (Cash ETR)
as the ratio of the sum of the cash tax payments over a five-year period to the sum of income
before taxes and special items over the same five-year period. To calculate tax risk (Tax Risk),
we compute the annual Cash ETR (cash taxes paid for the year scaled by income before taxes

11

Because fiscal years do not match up exactly with calendar years, some of our firms have a maximum of 20 years
of reported data, while others only have 19 years.

12

and special items for the year) over each of the five years in the sample period and calculate the
standard deviation of the five annual Cash ETRs. We use a rolling five-year window to calculate
each measure and include a firm if it has sufficient data for the five-year period to construct the
tax aggressiveness measures and sufficient data to calculate the subsequent years stock return
volatility. Examples of the calculation of the Cash ETR and standard deviation of the Cash ETR
can be found in Appendix A.
Our measure of tax aggressiveness is the FIN 48 UTB reserve scaled by lagged total
assets. Because the UTB reserve is only available for a limited set of firms for a few years (20072011), the sample for tests that require the UTB reserve is limited to the 1,960 firm-years for
which the UTB data are available. In addition, because firms can only be included in the sample
for a maximum of 4 years, we replace the firm fixed effects with industry fixed effects in tests on
the UTB sample.
The dependent variable in our analysis is the volatility of stock returns (StdDev_Return).
To compute the volatility we use the standard deviation of the twelve monthly returns in the
fiscal year immediately following the last of the five years used in our tax measures.

3.2 Research Design

To examine the association between tax policies and firm risk, we separately regress the
subsequent year stock return volatility on each tax policy measure and a common set of control
variables derived from prior research.
SD_Retit+1 = 0 + 1TAXit + 2PTBIt + 3Vol_of_PTBIit + 4BTMit
+5Leverageit +6Sizeit + 7Abn_Accrualsit + 8Returnit+1 +
+ 9Shares_Outit + 10Inst_Ownit1 + it

(1)

13

To calculate our variables we use the following formulas (Compustat Variable Name):
SD_Ret

= standard deviation of monthly stock returns;

TAX

= either Cash ETR, Tax Risk, or UTB, where Cash ETR is the five year sum
(measured from year t-4 to year t) of cash taxes paid (TXPD) divided by the
five-year sum of pre-tax income (PI) less special items (SPI). Tax Risk is the
standard deviation of annual Cash ETRs over the previous 5 years, or UTB,
calculated as the balance of the unrecognized tax benefits (TXTUBEND)
scaled by lagged total assets (AT);12

PTBI

= pretax book income (PTBI) scaled by lagged total assets;

Vol_of_PTBI

= standard deviation of the ratio of annual pretax income (PI) to lagged total
assets (AT) measured over a five-year period;

BTM

= year-end book value of equity (CEQ) over the price per share (PRCC_F)
times the total number of shares outstanding (CSHO);

Leverage

= year-end long-term debt (DLTT) scaled by lagged total assets;

Size

= natural log of total assets (AT);

Abn_Accrual

= square of year-end discretionary accruals, estimated using the modified Jones

model from Dechow et al. (1995);

Return

= firms annual buy and hold stock return measured over the fiscal year;

Shares Out

= log of the firms common shares outstanding (CSHO); and

Inst Own

= firms average institutional ownership measured over the fiscal year.

As noted above, we use the standard deviation of returns rather than systematic risk (i.e.,
beta) because we are interested in the impact of tax policies on the overall risk of the firm, as
12

To have a meaningful interpretation of the Cash ETR we require positive pretax income and we winsorize the
Cash ETR at 0 and 1 (following Dyreng et al 2008).

14

reflected in the riskiness of the firms cash flows. We use pretax income from operations to
control for the firms operating performance, which has been shown to be negatively associated
with stock return volatility (Hanlon et al. 2004). The volatility of pretax income measured over
the same period as the tax rate variables controls for the riskiness of the firms operations.13 The
book-to-market variable controls for the extent of the firms growth opportunities, which we
expect to be positively associated with stock return volatility. We include financial leverage to
control for the additional risk imposed by financial distress and capital constraints (Rajgopal and
Venkatachalam 2011). We control for size since smaller firms experience greater return volatility
(Pastor and Veronesi 2003). The extent of discretionary accruals controls for the risk associated
with lower earnings quality (Rajgopal and Venkatachalam 2011). We also control for the firms
stock return over the current year, as stock return is negatively related to return volatility (Duffie
1995). To control for stock trading differences due to investor composition, we include the firms
average institutional ownership over the year (Bushee and Noe 2000). Finally, we include the
number of shares outstanding in the current year, as the supply of a firms shares has been shown
to be a significant determinant of stock return volatility (Cohen, Ness, Okuda, Schwartz and
Whitcomb 1975).
Our regression specification also includes firm and year fixed effects for the full sample
and industry and year fixed effects for the UTB sample. A Hausman test between fixed and
random effects indicates that OLS is not consistent and that fixed effects are appropriate. As
noted above, we have a substantial number of firms included in the sample multiple times. By
including firm fixed effects the regression explains deviations from the average return volatility
for each firm and therefore reduces potential problems associated with firm-specific omitted

13

In unreported sensitivity tests we use the standard deviation of cash flows from operations and sales instead of
pretax income to control for the riskiness of the firms operations. Inferences are unchanged.

15

variables that are correlated with the firms average stock return volatility.14 The year fixed
effect controls for differences in tax laws and other macroeconomic effects across time.

3.3 Descriptive Statistics

Table 2 presents descriptive statistics for the dependent and independent variables used in
the regressions. The mean (median) Cash ETR of 28.9% (30%) is similar to the levels reported in
prior research. The distribution of the standard deviation of Cash ETR appears to be positively
skewed with a mean of 11.6% and median of 7.7%.
Table 3 provides data regarding the correlations between our tax policy measures. The
data reported in Panels A and C include observations for the restricted sample for which UTB
data are available. The data in Panel B are based on the full sample. The pairwise correlation
coefficients presented in Panel A indicate a strong positive correlation between the level of Cash
ETR and tax risk. Because a low Cash ETR is indicative of a high degree of tax avoidance, this
suggests that firms that avoid taxes pay a fairly stable proportion of pretax income in taxes.
Similarly, we find significantly negative correlations between the Cash ETR and UTB reserve,
which is consistent with firms that avoid tax taking more aggressive tax positions. However, the
relation between tax risk and tax aggressiveness is less clear. Although the Pearson correlation
coefficient is significantly negative, it is small (-0.090) and the Spearman Rank correlation
coefficient is not significant (-0.002).
To further illustrate the relationships among tax avoidance, tax aggressiveness and tax
risk we compare the number of observations in common quintiles. Panel B of Table 1 compares
tax avoidance and tax risk. As there are 25 possible combinations, the expected number of

14

In our tests using the UTB sample, we re-estimate these regressions using industry (two-digit SIC code) effects
instead of firm effects and find similar results.

16

observations in each cell is approximately 667, or 1/25 of the total of 16,686. Consistent with the
positive correlation, we find that firms with extremely low tax rates tend to have low risk. A total
of 871 observations fall in the lowest quintile of both Cash ETR and standard deviation of Cash
ETR. Similarly, firms that have high levels of tax risk tend to have high Cash ETRs. A total of
1,183 observations are in the high tax rate, high tax risk quintile combination.
These results suggest that tax policies that reduce the amount of taxes paid do not
increase the volatility of the firms tax payments. To a certain extent, this is mechanical given
that the Cash ETRs are computed over a five-year period, i.e., firms in the lowest Cash ETR
quintile probably didnt pay a high amount of taxes in any of the five years. However, we also
note that although the highest concentration of observations from the low Cash ETR quintile row
is in the lowest Cash ETR column, there are at least 500 observations in each cell in the row.
The relation between tax aggressiveness and tax risk (Panel C of Table 3) is less clear.
Because UTB data are only available after 2007, the number of observations declines to 1,960
leading to expected value of 78 observations in each cell (assuming random distribution). The 82
observations in the high UTB, high tax risk cell is only slightly higher than the 78 observations
based on random assignment. The cell with the highest number of observations (107) includes
firms that are in the lowest UTB quintile and highest volatility quintile. Thus, the evidence does
not appear to suggest that firms that take aggressive tax positions (as measured by the UTB
reserve) experience volatile tax payments.
To provide more evidence on the stability of low tax rates, we estimate separate logit
regressions with the dependent variable equal to one if the firm is in the lowest (highest) quintile
of Cash ETR, and zero otherwise. In each regression the variable of interest is equal to one if the
firm was in the lowest (highest) Cash ETR quintile in the latest non-overlapping five-year

17

period, and zero otherwise. The regressions also include year dummy variables. The coefficient
on the lagged indicator variable can be used to assess the persistence of the firms tax rate. We
present the results in Panel D of Table 3. In Column (1) the coefficient on the lagged Cash ETR
quintile variable of 2.346 indicates that a firm that is in the lowest Cash ETR is 10 times (e2.346)
more likely to be in the lowest Cash ETR quintile computed over the next five-year (nonoverlapping) period than firms that are not in the lowest quintile. In contrast, the coefficient on
the lagged indicator variable for the highest Cash ETR quintile of 1.211 shown in Column (2)
indicates that a firm in the highest Cash ETR quintile is only 3 times (e1.211) more likely to
remain in the highest Cash ETR quintile. These results suggest that low tax rates are more
persistent than high tax rates, and that firms who are able to lower their tax payments are often
able to sustain those positions over a long period of time.
Panel D of Table 3 presents the Pearson and Spearman pairwise correlations for the full
sample. There appear to be significant correlations between the volatility of stock returns and
each of our control variables, with the strongest correlations with the volatility of pretax income
and size. Tax avoidance seems to be most highly correlated with size, institutional ownership and
the number of outstanding shares, where tax risk appears to be most highly correlated with pretax
income, the book to market ratio, and shares outstanding.

3.4 The Determinants of Tax Avoidance, Tax Aggressiveness and Tax Risk
To provide insight into the factors that generate high tax avoidance, tax aggressiveness or
tax risk, we regress the incidence of being in the lowest Cash ETR quintile, highest UTB reserve
quintile, or highest standard deviation of Cash ETR quintile, on firm characteristics that are
likely to affect the firms tax payments. For consistent comparisons across regressions we

18

conduct this test using only our sample of firm-year observations that also have data available for
UTBs. Specifically, we estimate the following logit regression:15
Tax_Quintileit = 0 + 1Sizeit + 2PPEit + 3Foreign_Salesit + 4R&Dit + 5Intang_Assetsit
+ 6ESO_Benefitit + 7Leverageit + it

(2)

Where:
Tax_Quintile

= alternately, High Tax Avoidance, which is equal to one if the observation is in

the lowest Cash ETR quintile and zero otherwise, High Tax Aggressiveness,
which is equal to one if the observation is in the highest quintile of
Unrecognized Tax Benefits and zero otherwise, or High Tax Risk, which is
equal to one if the observation is in the highest standard deviation of Cash
ETR quintile, and zero otherwise;

PPE

= net property plant and equipment (PPENT) scaled by lagged total assets;

Foreign_Sales = foreign sales (foreign sales from geographic segments) divided by total sales
(sale), where foreign sales is set to 0 if missing;
R&D

= research and development expense (XRD) scaled by lagged total assets;

Intang Assets

= intangible Assets (INTAN) scaled by lagged total assets;

ESO_Benefit

= the excess tax benefit of stock options (TXBCOF) scaled by lagged total
assets, and other variables are as previously defined; and

Leverage

= year-end long-term debt (DLTT) scaled by lagged total assets.

We include size to capture the firms investment in tax savings. To the extent there are
economies of scale in tax investments, larger firms are able to invest more in tax departments to
find tax savings. The relative investment in net property, plant, and equipment is included to

15

Detailed variable definitions for the Logit Prediction Model can also be found in Appendix B.

19

capture the value of the depreciation tax shield. Because tax rates in foreign jurisdictions are
often lower than domestic rates, we include foreign sales. We include research and development
expenditures to capture the various tax credits that are available for research activities. We
include intangible assets because these assets are easier to transfer between operating units and
have therefore been associated with income shifting (either between countries or between states)
to lower tax payments. The excess tax benefit from stock option exercises affects tax rates
because the amount of the tax deduction is based the ex post gain on exercise, while the amount
of the option expense is based on the ex-ante value of the stock option. Finally, we include
leverage to capture the debt tax shield. We conduct our tests on the limited sample for which
UTB data are available, include year fixed effects and cluster standard errors by firm.
The results of estimating equation (2) are presented in Table 4. Column (1) indicates that
firms that display high tax avoidance (low Cash ETRs) have significantly higher investments in
property, plant, and equipment, have higher levels of research and development, greater tax
benefit from the exercise of options by employees and higher financial leverage. These results
are consistent with firms using tax shields to reduce their tax payments. The greater tax benefit
from the exercise of stock options is consistent with the Rego and Wilson (2012) finding that
firms that avoid taxes tend to utilize more stock options. However, attributing the relation to the
need to provide risk-taking incentives to encourage tax avoidance assumes that tax avoidance
activities increase firm risk.
The results in column (2) of Table 4 show that tax aggressive firms (high UTB reserves)
are significantly larger, have lower investments in PPE, a greater proportion of foreign sales and
higher R&D expenditures. The positive relation with size is consistent with larger firms investing
greater resources into taking aggressive tax positions. The negative coefficient on property, plant

20

and equipment, combined with the positive coefficients on foreign income and R&D
expenditures are consistent with tax aggressive firms utilizing foreign subsidiaries to reduce their
tax payments.16 Unlike high tax avoidance firms, firms that display high tax aggressiveness do
not have significantly higher tax benefits from employee stock option exercises or greater
degrees of leverage than non-tax aggressive firms.
The results reported in column (3) of Table 4 indicate that firms that display high tax risk
tend to be smaller than the average firm. This is consistent with smaller firms not having the
resources to invest in devising sustainable tax policies. High tax risk firms also have lower
investments in intangible assets, lower tax benefit from stock options, and higher leverage than
average firms.
Overall, Table 4 documents that there are a large number of differences in the
characteristics of firms that have high tax avoidance, aggressiveness and risk. Specifically, while
firms with high tax avoidance are able to take advantage of the tax shields associated with
accelerated depreciation, research and development expenditures, employee stock option
exercises and interest payments, high tax aggressive firms are larger firms that generate a higher
degree of foreign sales, have lower investments in property, plant and equipment, and higher
investments in research and development. In contrast, firms that have volatile Cash ETRs tend to
be smaller firms with fewer intangible assets, fewer employee stock option exercises and a
higher degree of leverage than the average firm.

16

Because it is easier to transfer intangible assets than physical assets, firms often use intangible assets to transfer
income to low tax jurisdictions. The positive coefficient on R&D and the insignificant coefficient on intangible
assets suggest that tax aggressive firms are more likely to use internally generated intangible assets to shift income.

21

3.5 Regression Analysis

To test whether tax avoidance, tax aggressiveness or tax risk is associated with firm risk,
we estimate regression equation (1) for each tax policy measure and report the results in Table 5.
Panel A of Table 5 presents the results for the full sample. In each regression, the dependent
variable is the one-year ahead stock return volatility measured as the standard deviation of
twelve monthly stock returns. In columns 1 and 2 we report the results for tax avoidance and tax
risk without the control variables. These results differ from the pairwise correlations because
they include both year and firm fixed effects. We find an insignificant coefficient for the Cash
ETR (column 1) and a significantly positive coefficient on tax risk (column 2). We find similar
results in Columns 3 and 4 when we include the control variables. The insignificant relations for
the Cash ETR raise questions as to whether tax avoidance, per se, is a risky activity. The
significantly positive coefficient for the standard deviation of the annual cash ETR suggests that
tax avoidance is only a risky activity if the firm is unable to sustain its tax positions over time.
Our results also suggest that the degree of uncertainty regarding the firms tax rate is associated
with the riskiness of the firms after-tax cash flows.
The results for the control variables are generally significant in the expected directions.
The exceptions are insignificant relations for our measures for expected growth (book to market),
and accounting quality (abnormal accruals), and significantly positive relations for firm
performance (stock return and pretax book income). The insignificant results could be attributed
to their effect being reflected in the other independent variables. The positive relation between
performance and future volatility could be due to the composition of our sample. We require
firms to have six consecutive years of data and five consecutive years of positive pretax book
income. As a result, firms in financial distress, which are generally responsible for the negative

22

relation between performance and volatility, are excluded from our sample.
Panel B of Table 5 reports the results from the estimation of equation (1) on the limited
sample with UTB data. In Columns 1-3 we present the results without control variables and in
Columns 46 we present the results after including the control variables. Because the limited
time period reduces the number of observations per firm, we replace the firm fixed effects used
in the full sample regressions with industry fixed effects. We retain year fixed effects. We find
insignificant coefficients for the level of the Cash ETR (columns 1 and 4) and the UTB reserve
(columns 2 and 5). Thus, we do not find evidence that tax avoidance or tax aggressiveness
increases the riskiness of the firms cash flows. On the other hand, we continue to find a positive
relation between tax risk and stock return volatility.
Overall, our results suggest that uncertainty regarding the firms tax rate, as reflected in
the standard deviation of the firms annual Cash ETR, increases uncertainty regarding the firms
cash flows, as reflected in the volatility of the firms stock return. Tax policies that reduce the
firms tax payments or increase the firms UTB reserve only increase firm risk if they also
increase the volatility of the firms tax payments. Tax policies, whether aggressive or not, that
lead to relatively stable tax payments over time do not appear to increase firm risk.
The regression results reported in Table 5 assume a linear relation between the tax
measures and stock return volatility. However, it is possible that the impact on firm risk is
concentrated in extreme tax policies. In other words, while there may be relatively weak overall
relations between tax avoidance, or tax aggressiveness, and firm risk, unusually large degrees of
tax avoidance or aggressiveness could be still lead to a high degree of volatility. This effect
could be obscured by the inclusion of firms for which the relation is small, or nonexistent. To
provide evidence on this question we define indicator variables that are set equal to one if the

23

firm is in either the lowest quintile of Cash ETR, the highest quintile of the UTB reserve, or the
highest standard deviation of Cash ETR quintile. We then replace the continuous tax variables
with the indicator variables in estimating equation (1).
Table 6 reports the results using the indicator variables for extreme quintiles. Panel A of
Table 6 presents the results for the full sample and Panel B of Table 6 presents the results for the
limited UTB sample. In both samples, the coefficients for the high tax avoidance and high tax
aggressiveness indicator variables are not significant. Thus we do not find evidence that
displaying an unusually high degree of tax avoidance or tax aggressiveness increases firm risk.
The coefficients for the high tax risk indicator variable remain significantly positive. This is
consistent with unusually high tax risk leading to higher firm risk.
Finally, we consider the coefficient of variation of the Cash ETR as an alternative
measure of tax risk. The coefficient of variation scales the standard deviation by the mean of the
Cash ETR. Thus, the coefficient of variation considers volatility relative to the mean, or converts
raw differences to percentage differences. For example, consider a firm that has a mean Cash
ETR of 15% and a firm that has a mean Cash ETR of 35% and assume that both firms receive a
shock that increases the mean by 5% of pretax book income, i.e., to 20% and 40%. The standard
deviation of the Cash ETR would treat the shock equally for both firms, i.e., going from 15% to
20% is equivalent to going from 35% to 40%. However the coefficient of variation would
consider the shock to be greater for the low Cash ETR firm because the 5% increase is a greater
percentage increase for the low Cash ETR firm.
Panels A, B, and C of Table 7 present the correlations between the coefficient of
variation of Cash ETR, the level of the Cash ETR and UTB reserves. Not surprisingly, dividing
the standard deviation by the mean generates a negative correlation between the coefficient of

24

variation and the level of the Cash ETR. Whether this induces or removes a bias in the volatility
measure depends on whether the underlying uncertainty in the firms tax rate is best captured by
variation in the tax rate or the percentage variation in the tax rate.
To assess whether the relation between tax risk and firm risk is sensitive to the measure
of tax risk, we replace the standard deviation of the Cash ETR with the coefficient of variation of
the Cash ETR and estimate equation (1). The results presented in Panel D of Table 7 indicate a
significantly positive relation between the coefficient of variation of the Cash ETR and future
stock price volatility. Thus, the conclusion that uncertainty regarding the firms tax rate increases
overall firm risk is unchanged.

4. Conclusion
We consider different characteristics of a firms tax policies and examine whether they
are associated with future firm risk. Our paper is motivated by the recent appearance of research
papers that assume that tax avoidance or tax aggressiveness increases the risk of the firm. We
define three different tax concepts and specify empirical measures for each concept. Tax
avoidance represents the ability of the firm to reduce its tax payments and is measured by the
cash effective tax rate. Tax aggressiveness represents the extent to which the firm takes tax
positions that are unlikely to be supported by the tax authorities and is measured by the reserve
for unrecognized tax benefits, scaled by lagged total assets. Tax risk represents the ability of the
firm to sustain its tax positions over time, and is measured by the standard deviation of the
annual cash effective tax rates.
We first compare the three tax policy measures, and do not find evidence that high tax
avoidance, or high tax aggressiveness is associated with high tax risk. Firms that follow tax

25

policies that lower their tax payments are able to sustain their tax positions over time and high
reserves for uncertain tax benefits are not associated with volatile tax rates. We also find that
each tax concept appears to have differential relations with underlying firm characteristics.
In our main tests we examine whether the extent of a firms tax avoidance, tax
aggressiveness or tax risk is associated with firm risk. Our results indicate that tax risk is
positively associated with overall firm risk, as measured by the one-year ahead standard
deviation of monthly stock returns. However, we do not find evidence of a significant relation
between future stock return volatility and either tax avoidance or tax aggressiveness. Our results
suggest that tax policies only increase the risk of the firm if they increase the uncertainty
regarding the firms tax payments.
The results of our study make important contributions to tax research. First, our evidence
suggests that a low cash tax rate is not associated with higher risk, as measured by future stock
return volatility. This has implications for interpreting the results of prior studies that suggest
that activities that reduce the firms tax payments increase the firms risk. Second, our evidence
supports the standard deviation of the annual Cash ETR as a measure of tax risk and suggests
that tax risk is an important component of overall firm risk. Finally, our results suggest that the
level of Cash ETR, UTB reserve and the standard deviation of Cash ETR reflect different types
of tax policies.

26

References
Armstrong, C., J. Blouin and D. Larcker. 2012. The incentives for tax planning. Journal of
Accounting and Economics 53: 391-411.
Brealey, R. and S. Myers. 1991. Principles of Corporate Finance Fourth Edition. McGraw-Hill,
Inc. New York.
Brown, J., K. Drake and M. Martin. 2013. Are firms myopic? The case of contracting on
performance and uncertainty. Working paper. Arizona State University.
Bushee, B. and C. Noe,. 2000. Corporate Disclosure Practices, Institutional Investors and Stock
Return Volatility. Journal of Accounting Research, Vol 38 Supplement. 171-202
Campbell, J., H. Chen, D. Dhaliwal, H. Lu, and L. Steele. 2013. The Information Content of
Mandatory Risk Factor Disclosures in Corporate Filings. Forthcoming in Review of
Accounting Studies
Cassel, C., S. Huang, J. Sancez, and M. Stuart. 2012. Seeking safety: The relation between CEO
inside debt holdings and the riskiness of firm investment and financial policies. Journal
of Financial Economics 103: 588-610.
Boivie, S., Christensen, D., Dhaliwal, D., Graffin, Scott, D. 2012. Managers' personal political
orientation and corporate tax avoidance. Working paper. University of Arizona.
Cochrane, J. 2001. Asset Pricing. Princeton University Press. Princeton New Jersey.
Cohen, K., W. Ness, H. Okuda, R. Schwartz, and D. Whitcomb. 1975. The Determinants of
Stock Return Volatility: An International Comparison. Journal of Finance XXI: 733-740.
Dechow, P., R. Soan and A. Sweeney. 1996. Detecting Earnings Management. 1993-225. The
Accounting Review 70: 193-225.

27

Dyreng, S., M. Hanlon and E. Maydew. 2008. Long run corporate tax avoidance. The Accounting
Review 83: 61-82.
Duffie, G. 1995. Stock Return and volatilty: a firm-level analysis. Journal of Financial
Economics 37: 399-420.
Ernst & Young. 2011. 2011-12 Tax risk and controversy survey. Available at:
http://www.ey.com/GL/en/Services/Tax/2011-12-Tax-risk-and-controversy-survey.
Fama, E. 1976. Foundations of Finance: Portfolio Decisions and Securities Prices. Basic Books,
New York.
Hanlon, M., S. Rajgopal and T. Shevlin. 2004. Large sample evidence on the relation between
stock options and risk taking. Working paper, University of Washington.
Higgins, D., T. Omer and J. Phillips. 2012. Tax avoidance versus aggressiveness: The influence
of a firms business strategy. Working paper, University of Connecticut.
Hutchins, M. and S. Rego. 2012. Tax Risk and the Cost of Equity Capital. Working paper,
Indiana University.
KPMG. 2011. Tax Governance Institute: Tax risk management e-survey. Available at:
http://www.kpmginstitutes.com/tax-governance-institute/insights/2011/pdf/tax-riskmanagement-survey-report.pdf.
Lisowsky, P., L. Robinson and A. Schmidt. 2013. Do publicly disclosed tax reserves tell us about
privately disclosed tax shelter activity? Journal of Accounting Research 51: 583-629.
Markowitz, H. 1952. Portfolio selection. The Journal of Finance 7: 77-91.
McGuire, S., S. Neuman and T. Omer. 2013. Sustainable Tax Strategies and Earnings
Persistence. Working paper, Texas A&M University.

28

Neuman, S., T. Omer and A. Schmidt. 2013. Risk and return: does tax risk reduce firms'
effective tax rates? Working paper, Texas A&M University and North Carolina State
University.
Pastor, L., and P. Veronesi. 2003. Stock valuation and learning about profitability. Journal of
Finance 58: 1749-1789.
Pennacchi, G. 2007. Theory of Asset Pricing. Prentice Hall. New Jersey.
Powers, M. 2009. Rethinking risk and return: Part 1 Novel norms for non-normality? Journal
of Risk Finance 10.
Pricewaterhouse Coopers. 2004. Tax risk management. Available at:
http://www.pwc.com/en_GX/gx/tax-management-strategy/pdf/tax-risk-managementguide.pdf.
Rajgopal, S. and M. Venkatachalam. 2011. Financial Reporting Quality and Idiosyncratic Return
Volatility. Journal of Accounting and Economics 51: 1-20.
Rego, S., and R. Wilson. 2012. Equity Risk Incentives and Corporate Tax Aggressiveness.
Journal of Accounting Research 50: 775-809.
Robinson, J., Y. Xue, and M. Zhang. 2012. Tax planning and financial expertise in the audit
committee. Working paper.

29

Appendix A
Tax Rate Examples
Panel A: High Tax Avoidance (Low Cash ETR)
IBM
(Dollars in billions)
Pre-tax income before special items
Cash taxes paid
Cash ETR
Annual Cash ETR
Mean annual Cash ETR
Standard deviation of Cash ETR
Coefficient of variation of Cash ETR

2003
$10.883
$1.707

2004
$12.473
$1.837

2005
$12.378
$1.994

2006
$13.265
$2.068

2007
$14.441
$2.608

15.69%

14.73%

16.11%

15.59%

18.06%

Total
$63.440
$10.214
16.10%
16.03%
0.011
0.07

Panel B: High Tax Risk

DPL Incorporated
(Dollars in millions)
Pre-tax income before special items
Cash taxes paid
Cash ETR
Annual Cash ETR
Mean Annual Cash ETR
Standard deviation of Cash ETR
Coefficient of Variation of Cash ETR

2002
$137.6
$104

2003
$252.0
$15.2

2004
$342.9
$107.9

2005
$265.8
$71.2

2006
$266.4
$113.6

75.58%

6.03%

31.47%

26.79%

42.64%

Total
$1264.7
$411.9
32.57%
36.60%
0.23
0.63

30

APPENDIX B Variable Definitions

Full-Sample Analysis
SD_Ret
Cash ETR

Tax Risk

UTB
Size
PTBI
BTM
Leverage
Abn_Accruals
Vol_of_PTBI
Return
Inst_Own

= the standard deviation of monthly stock returns measured the subsequent

year.
= the 5 year sum (from year t-4 to year t) of cash taxes paid (TXPD) divided
by the 5-year sum of pre-tax income (PI) less special items (SPI). In order to
allow for meaningful interpretation firms are required to have a positive
denominator and Cash ETR is winsorized at 0 and 1.
= the standard deviation of one-year cash ETR over the time period t-4 to t.
One year Cash ETR is defined as cash taxes paid (TXPD) divided by pretax
income (PI) less special items (SPI).
= unrecognized tax benefits (TXTUBEND) scaled by lagged total assets
(AT)
= natural log of total assets (AT)
= pretax book income (PI) scaled by lagged total assets (AT))
= book value of equity (CEQ) over price per share (PRCC_F) times total
common shares outstanding (CSHO)
= long-term debt (DLTT) scaled by lagged total assets
= the square of discretionary accruals, where discretionary accruals are
estimated using the Modified-Jones method from Dechow et al (1995)
= standard deviation (measured over the previous five years) of the ratio of
pretax book income (PI) to lagged total assets (AT)
= the firms annual buy and hold stock return measured over year t+1.
= the firms average institutional ownership measured over the fiscal

year.
Shares_Out

= the log of the firms common shares outstanding (CSHO).

Logit Prediction Model

Size
PPE
Foreign_Sales
R&D
Intang_Assets
ESO_Benefits
Leverage

= natural log of total assets (AT)

= Net Property Plant and Equipment (PPENT) scaled by lagged total
assets. PPE is set to 0 if missing.
= foreign sales (foreign sales from geographic segment data) over total
sales (sale), where foreign sales is set to 0 if missing.
= Research and development expense (XRD) scaled by lagged total
assets. XRD is set to 0 if missing
= intangible assets (INTAN) scaled by lagged assets.
= the excess tax benefit of stock options (TXBCOF) scaled by lagged
total assets. Stock Option Tax Benefit is set to 0 if missing.
= long-term debt (DLTT) scaled by lagged total assets

31

Table 1
Number of Observations per Firm

Number of Years Each

Firm Appears in the Sample
2

All Years

Number of
Firms
388

Number of
Observations
776

314

942

266

1064

191

955

178

1068

149

1043

124

992

113

1017

10

116

1160

11

116

1276

12

70

840

13

70

910

14

62

868

15

56

840

16

26

416

17

21

357

18

47

846

19

64

1216

20

100

2,376

16,686

This table provides data on the number of times each unique firm appears in our sample.

32

Table 2
Summary Statistics

Variable
Volatility of stock returns
Cash ETR
Cash ETR Volatility
PTBI
Volatility of PTBI
Book to Market
Leverage
Size
Abnormal accruals
Stock return
Institutional ownership
Shares outstanding

Mean

Standard
Deviation

25th
Percentile

50th
Percentile

75th
Percentile

16,686

0.098

0.048

0.063

0.088

0.121

16,686
16,686
16,686
16,686
16,686
16,686
16,686
16,686
16,686
16,686
16,686

0.289
0.116
0.139
0.043
0.507
0.194
6.468
0.124
0.078
0.452
3.444

0.115
0.144
0.099
0.041
0.323
0.188
1.881
0.596
0.385
0.272
1.503

0.224

0.300

0.359

0.047

0.077

0.126

0.068

0.115

0.183

0.017

0.031

0.052

0.283

0.446

0.650

0.014

0.163

0.305

5.145

6.400

7.738

0.000

0.003

0.016

-0.166

0.039

0.258

0.236

0.429

0.667

2.366

3.374

4.393

This table presents the summary statistics for the variables included in the full sample tests. All variables are as
defined in Appendix B. All continuous variables are winsorized at the 1st and 99th Percentiles.

33

Table 3
Pairwise Correlations of Tax Policy Measures
Panel A: Pairwise Correlations
Cash ETR

UTB

Tax Risk

1.00

-0.120

0.298

UTB

-0.147

1.00

-0.002

Tax Risk

0.135

-0.090

1.00

Cash ETR

Panel B: Cash ETR and Tax Risk ETR Quintiles

Number of observations in each quintile (~667 in each cell if evenly distributed)
Tax Risk
Quintile 1
871
502
687
783
495
3,338

Cash ETR Quintile 1

Cash ETR Quintile 2
Cash ETR Quintile 3
Cash ETR Quintile 4
Cash ETR Quintile 5
Total

Tax Risk
Quintile 2
605
676
708
776
572
3,337

Tax Risk
Quintile 3
641
797
725
634
540
3,337

Tax Risk
Quintile 4
690
832
680
588
547
3,337

Tax Risk
Quintile 5
531
530
537
556
1,183
3,337

Total
3,338
3,337
3,337
3,337
3,337
16,686

Panel C: UTB and Tax Risk Quintiles

Number of observations in each quintile (~78 in each cell if evenly distributed)

UTB Quintile 1
UTB Quintile 2
UTB Quintile 3
UTB Quintile 4
UTB Quintile 5
Total

Tax Risk
Quintile 1
64
79
83
86
80
392

Tax Risk
Quintile 2
49
77
88
83
95
392

Tax Risk
Quintile 3
78
76
81
82
75
392

Tax Risk
Quintile 4
94
80
85
73
60
392

Tax Risk
Quintile 5
107
80
55
68
82
392

Total
392
392
392
392
392
1,960

Panel D: Persistence of High and Low Tax Avoidance

(z-statistic)
Lowest Cash ETR
Highest Cash ETR
Quintile
Quintile
VARIABLES
(1)
(2)
Lagged Lowest ETR Quintile

2.346***
(28.13)

Lagged Highest ETR Quintile

1.211***
(16.11)

Number of Observations

6,360

6,360

Pseudo R^2

0.170

0.086

Yes

Yes

Year Fixed Effects?

34

Table 3: (Continued)
Panel E: Pairwise Correlations of Variables
Variablesa
I Volatility of
Stock Returns
II Cash ETR
III Tax Risk
IV PTBI
V Volatility of
PTBI
VI Book to
Market
VII Leverage
VIII Size
IX Abnormal
Accruals
X Return
XI Institutional
Ownership
XII Shares
Outstanding

II

III

IV

VI

VII

VIII

IX

XI

XII

1.000
0.024
0.118
0.126

0.005
1.000
0.135
0.073

0.099
0.298
1.000
-0.309

0.130
0.013
-0.199
1.000

0.300
-0.004
0.098
0.395

0.066
0.117
0.221
-0.498

-0.067
-0.126
0.026
-0.301

-0.258
-0.157
-0.131
-0.191

0.025
-0.043
0.007
0.035

0.056
0.002
0.057
-0.103

0.031
0.207
0.135
-0.077

-0.149
-0.178
-0.169
0.040

0.376

0.037

0.113

0.343

1.000

-0.134

-0.178

-0.255

0.050

0.019

-0.009

-0.084

-0.008
-0.129
-0.265

0.118
-0.141
-0.211

0.263
0.053
-0.131

-0.590
-0.403
-0.172

-0.186
-0.293
-0.305

1.000
0.118
-0.197

0.032
1.000
0.359

-0.217
0.281
1.000

-0.039
-0.042
0.006

0.230
-0.020
-0.065

0.257
-0.039
-0.480

-0.393
0.113
0.894

0.138
-0.059

-0.060
0.005

0.045
0.040

0.130
-0.115

0.197
-0.007

-0.109
0.199

-0.149
-0.010

-0.110
-0.019

1.000
0.009

0.029
1.000

-0.066
0.043

0.034
-0.049

-0.012

0.229

0.124

-0.093

-0.042

0.256

-0.031

-0.477

-0.061

0.016

1.000

-0.463

-0.152

-0.216

-0.197

0.051

-0.124

-0.401

0.168

0.896

-0.043

-0.018

-0.488

1.000

This table provides data on the pairwise correlations between the tax policy measures. In Panels A and E, Pearson
correlation coefficients are above the diagonal and Spearman Rank correlations are below the diagonal. Panels B
and C demonstrate the relations between tax risk and levels of tax avoidance (Panel B) and tax aggressiveness
(Panel C). Data in Panels A and C are limited to observations for which UTB data are available. Panel D presents
the results from a logit regression with the dependent variable equal to one if the firm is in the lowest (highest)
quintile of the Cash ETR. The independent variables are indicator variables equal to one if the firm is in the lowest
(highest) quintile of the Cash ETR distribution in the prior (non-overlapping) five-year period. Tax risk is the
standard deviation of the annual Cash ETR over a five year period. Detailed definitions for the variables are reported
in Appendix B.

35

Table 4:
Determinants of High Tax Avoidance, High Tax Aggressiveness and High Tax Risk

VARIABLES
Size
PPE
Foreign_Sales

High Tax
Avoidance
(1)

High Tax
Aggressiveness
(2)

High Tax
Risk
(3)

0.108*

0.208***

-0.231***

(1.56)

(3.41)

(-4.54)

1.182**

-1.329**

0.241

(2.47)

(-2.46)

(0.58)

0.720

1.747***

-0.084

(1.19)

(3.00)

(-0.16)

12.704***

10.343***

0.431

(5.80)

(4.75)

(0.19)

0.428

-0.833

-1.158**

(0.90)

(-1.58)

(-2.72)

55.879***

16.492

-87.879***

(3.17)

(0.89)

(-3.93)

1.011*

0.570

1.043**

(1.93)

(0.89)

(2.06)

Yes

Yes

Yes

R^2

0.077

0.098

0.051

Observations

1,960

1,960

1,960

R&D
Intang_Assets
ESO_Benefit
Leverage
Year Fixed Effects?

* **

, , and ***indicate statistical significance at the 0.10, 0.05 and 0.01 levels, respectively.
The dependent variable is either set equal to one if the observation is in the lowest quintile of Cash ETR and zero
otherwise (Column 1 High Tax Avoidance), equal to one if the observation is in the highest quintile of unrecognized
tax benefits and zero otherwise (Column 2 High Tax Aggressiveness), or equal to one if the observation is in the
highest quintile of the standard deviation of Cash ETR and zero otherwise (Column 3 High Tax Risk),. T-statistics
are in parenthesis and reflect standard errors clustered by firm. Intercepts and Year Effects are included in the
analysis but are not tabulated. All variables are defined in Appendix B.

36

Table 5:
The Relation between Tax Policies and Firm Risk
Panel A: Full Sample
VARIABLES
Cash ETR

Predicted
Sign
(-)

Tax Risk

(+)

PTBI

(-)

Vol_of_PTBI

(+)

BTM

(-)

Leverage

(+)

Size

(-)

Abn_Accruals

(+)

Return

(-)

Inst_Own

(+)

Shares_Out

(+)

Constant

(?)

Firm Fixed Effects?

Year Fixed Effects?
N
R-Squared

1
0.472
(0.84)

3
0.374
(0.69)

1.916***
(4.61)

9.326***
(21.23)
Yes
Yes
16,686
0.220

9.237***
(23.23)
Yes
Yes
16,686
0.221

1.823***
(2.75)
11.53***
(6.93)
0.267
(1.04)
2.344***
(6.94)
-0.725***
(-4.26)
0.0381
(0.66)
0.368***
(3.12)
0.546
(1.54)
0.319**
(2.18)
10.82***
(12.07)
Yes
Yes
16,686
0.233

1.555***
(3.72)
2.130***
(3.21)
10.76***
(6.40)
0.224
(0.88)
2.302***
(6.86)
-0.675***
(-3.99)
0.0386
(0.67)
0.368***
(3.12)
0.542
(1.54)
0.325**
(2.23)
10.48***
(11.89)
Yes
Yes
16,686
0.234

37

Table 5:
The Relation between Tax Policies and Firm Risk
Panel B: UTB Sample
VARIABLES
Cash ETR

Predicted
Sign
(-)

UTB

(+)

Tax Risk

(+)

PTBI

(-)

Vol_of_PTBI

(+)

BTM

(-)

Leverage

(+)

Size

(-)

Abn_Accruals

(+)

Return

(-)

Inst_Own

(+)

Shares_Out

(+)

Constant

(?)

Industry Fixed Effects?

Year Fixed Effects?
N
R-Squared

1
1.970
(1.25)

4
-0.407
(-0.33)

-11.55
(-1.44)

9.209
(1.23)
5.785***
(4.56)

13.17***
(33.23)
Yes
Yes
1,960
0.279

13.84***
(45.76)
Yes
Yes
1,960
0.279

13.28***
(52.46)
Yes
Yes
1,960
0.300

-2.254
(-1.60)
22.98***
(6.44)
2.564***
(5.49)
3.810***
(5.48)
-0.787***
(-4.75)
0.171**
(2.19)
0.0529
(0.19)
-2.536***
(-4.40)
0.0724
(0.37)
19.33***
(20.94)
Yes
Yes
1,960
0.412

-2.407*
(-1.69)
22.66***
(6.21)
2.608***
(5.58)
3.766***
(5.42)
-0.774***
(-4.67)
0.172**
(2.21)
0.0419
(0.15)
-2.557***
(-4.43)
0.0331
(0.17)
19.20***
(22.03)
Yes
Yes
1,960
0.413

2.659***
(2.59)
-1.392
(-0.92)
20.76***
(5.95)
2.580***
(5.63)
3.759***
(5.45)
-0.769***
(-4.69)
0.167**
(2.16)
0.00766
(0.03)
-2.624***
(-4.66)
0.0866
(0.45)
18.89***
(21.05)
Yes
Yes
1,960
0.416

* **

, , and ***indicate statistical significance at the 0.10, 0.05 and 0.01 levels, respectively. The dependent variable in
the analysis is the volatility of stock returns at year t+1. T-Statistics are in parenthesis and reflect standard errors that
are clustered by firm. All variables are as defined in Appendix B. For expositional convenience we multiply all
coefficients by 100.

38

Table 6:
The Relation between Extreme Tax Policies and Firm Risk
Panel A: Full Sample
VARIABLES
Low Cash ETR

Predicted
Sign
(+)

High Tax Risk

(+)

PTBI

(-)

Vol_of_PTBI

(+)

BTM

(-)

Leverage

(+)

Size

(-)

Abn_Accruals

(+)

Return

(-)

Inst_Own

(+)

Shares_Out

(+)

Constant

(?)

Firm Fixed Effects?

Year Fixed Effects?
N
R-Squared

1
-0.0777
(-0.59)

3
-0.0632
(-0.50)

0.422***
(3.56)

9.491***
(24.24)
Yes
Yes
16,686
0.218

9.386***
(23.88)
Yes
Yes
16,686
0.220

1.814***
(2.73)
11.57***
(6.95)
0.271
(1.06)
2.337***
(6.93)
-0.723***
(-4.25)
0.0385
(0.67)
0.368***
(3.12)
0.549
(1.55)
0.314**
(2.15)
10.95***
(12.45)
Yes
Yes
16,686
0.233

0.308***
(2.69)
1.949***
(2.93)
11.22***
(6.74)
0.237
(0.93)
2.316***
(6.91)
-0.698***
(-4.12)
0.0377
(0.65)
0.370***
(3.14)
0.535
(1.51)
0.319**
(2.18)
10.75***
(12.17)
Yes
Yes
16,686
0.233

39

Table 6:
The Relation between Extreme Tax Policies and Firm Risk
Panel B: UTB Sample
VARIABLES
Low Cash ETR

Predicted
Sign
(-)

High Tax Risk

(+)

High UTB

(+)

PTBI

(-)

Vol_of_PTBI

(+)

BTM

(-)

Leverage

(+)

Size

(-)

Abn_Accruals

(+)

Return

(-)

Inst_Own

(+)

Shares_Out

(+)

Constant

(?)

Industry Fixed Effects?

Year Fixed Effects?
N
R-Squared

1
-0.0672
(-0.23)

4
0.118
(0.48)

1.501***
(5.19)

0.543**
(1.98)
-0.385
(-1.20)

13.60***
(54.80)
Yes
Yes
1,960
0.277

13.58***
(54.71)
Yes
Yes
1,960
0.294

13.61***
(54.95)
Yes
Yes
1,960
0.278

-2.229
(-1.56)
22.83***
(6.21)
2.556***
(5.52)
3.809***
(5.49)
-0.785***
(-4.74)
0.171**
(2.18)
0.0560
(0.20)
-2.543***
(-4.41)
0.0695
(0.35)
19.25***
(21.92)
Yes
Yes
1,960
0.412

-1.820
(-1.25)
21.56***
(5.93)
2.515***
(5.45)
3.806***
(5.53)
-0.778***
(-4.75)
0.168**
(2.16)
0.0595
(0.22)
-2.569***
(-4.48)
0.0817
(0.42)
19.15***
(21.62)
Yes
Yes
1,960
0.414

0.195
(0.70)
-2.335
(-1.65)
22.65***
(6.20)
2.584***
(5.56)
3.815***
(5.50)
-0.786***
(-4.75)
0.171**
(2.19)
0.0409
(0.15)
-2.561***
(-4.44)
0.0626
(0.32)
19.32***
(21.67)
Yes
Yes
1,960
0.412

* **

, , and ***indicate statistical significance at the 0.10, 0.05 and 0.01 levels, respectively. The dependent variable in
the analysis is the volatility of stock returns at year t+1. T-Statistics are in parenthesis and reflect standard errors that
are clustered by firm. All variables are as defined in Appendix B. For expositional convenience we multiply all
coefficients by 100.

40

Table 7
Coefficient of Variation of Cash ETR
Panel A: Pairwise Correlations
Cash ETR

UTB

Coefficient
of Variation

1.00

-0.129

-0.281

UTB

-0.159

1.00

0.058

Coefficient of Variation

-0.361

0.001

1.00

Cash ETR

Panel B: Cash ETR and Coefficient of Variation of ETR Quintiles

Number of observations in each quintile (~662 in each cell if evenly distributed)

Cash ETR Quintile 1

Cash ETR Quintile 2
Cash ETR Quintile 3
Cash ETR Quintile 4
Cash ETR Quintile 5
Total

Coefficient
of Variation
Quintile 1
94
371
751
1,139
955
3,310

Coefficient
of Variation
Quintile 2
238
636
855
845
735
3,309

Coefficient
of Variation
Quintile 3
441
865
792
639
573
3,310

Coefficient
of Variation
Quintile 4
899
900
576
422
512
3,309

Coefficient
of Variation
Quintile 5
1,638
537
336
264
534
3,309

Total
3,310
3,309
3,310
3,309
3,309
16,547

Panel C: UTB and Tax Risk Quintiles

Number of observations in each quintile (~78 in each cell if evenly distributed)

UTB Quintile 1
UTB Quintile 2
UTB Quintile 3
UTB Quintile 4
UTB Quintile 5
Total

Coefficient
of Variation
Quintile 1
68
92
91
84
57
392

Coefficient
of Variation
Quintile 2
66
79
80
90
76
391

Coefficient
of Variation
Quintile 3
75
80
89
66
81
391

Coefficient
of Variation
Quintile 4
80
67
76
84
84
391

Coefficient
of Variation
Quintile 5
103
73
55
67
93
391

Total
392
391
391
391
391
1,956

Panels A, B, and C in this table provides data on the relation between the coefficient of variation of Cash ETR and
other tax policy measures. In Panel A, Pearson correlation coefficients are above the diagonal and Spearman Rank
correlations are below the diagonal. Panels B and C demonstrate the relations between the coefficient of variation
and levels of tax avoidance (Panel B) and tax aggressiveness (Panel C). Detailed definitions for the variables are
reported in Appendix B.

41

Table 7: (Continued)
Panel D: The Coefficient of the Cash ETR and Firm Risk
VARIABLES
Coefficient of variation

Full
Sample
0.534***
(3.79)

PTBI
Vol_of_PTBI
BTM
Leverage
Size
Abn_Accruals
Return
Inst_Own
Shares_Out
Constant
Firm Fixed Effects?
Year Fixed Effects?
N
R-Squared

9.302***
(22.64)
Yes
Yes
16,547
0.222

Full
Sample
0.370***
(2.67)
2.101***
(3.13)
11.39***
(6.70)
0.267
(1.04)
2.300***
(6.74)
-0.676***
(-3.95)
0.0225
(0.38)
0.353***
(3.00)
0.519
(1.45)
0.294**
(2.00)
10.59***
(11.80)
Yes
Yes
16,547
0.235

UTB
Sample
1.754***
(5.38)

13.12***
(49.41)
Yes
Yes
1,956
0.293

UTB
Sample
0.818***
(2.87)
-1.483
(-1.01)
22.27***
(6.00)
2.543***
(5.49)
3.745***
(5.42)
-0.758***
(-4.61)
0.174**
(2.19)
0.0541
(0.20)
-2.498***
(-4.34)
0.0717
(0.37)
18.72***
(20.81)
Yes
Yes
1,956
0.414

* **

, , and ***indicate statistical significance at the 0.10, 0.05 and 0.01 levels, respectively. The dependent variable in
the analysis is the volatility of stock returns at year t+1. T-Statistics are in parenthesis and reflect standard errors that
are clustered by firm. All variables are as defined in Appendix B. For expositional convenience we multiply all
coefficients by 100.

42