Sample Finance Paper on Impact of Aggressive State Tax Planning on Firm Value


Corporations employ tax professionals to help them prepare and file various tax returns at the international, federal, state and local levels.  These tax professionals also help their corporations structure their businesses and transactions in such a way as to minimize the amount of taxes the corporations owe.  Often a fine line separates tax minimization through legal techniques and the illegal avoidance of tax through subterfuge or fraud.  A corporation that engages in conservative tax planning would likely pay more taxes to avoid increased legal exposure from the taxing authorities.  A corporation that engages in aggressive tax planning would seek to reduce its taxes and take on the risk of increased legal exposure.  Thus, there is a tradeoff.

My research question is whether aggressive state and local tax planning has an impact on firm value.  My first hypothesis is that firms with a lower state and local tax expense will have a higher firm value.  My second hypothesis is that aggressive state and local tax planning will have a positive impact on firm value.  While state tax expenses tend to be significantly less than federal or international tax expenses, there still is an opportunity for tax savings.  That is, when a firm reduces its state tax expense, it will still earn a higher return and create more wealth for its owners.  Moreover, state tax planning does not carry the same reputational risks associated with federal or international tax planning.  The likelihood of state tax audits is less because state taxing authorities do not have the same resources as federal or international taxing authorities.  Further, state tax savings is spread over several states, meaning that a corporation will face a risk of audits on a state-by-state basis and not in the aggregate.  For example, if the state of New York challenges a corporation’s tax planning and succeeds, the corporation’s tax planning may still go unchallenged in the other forty-nine states.

There has already been good work done in this field.  Though no one has squarely addressed whether aggressive multistate tax planning has an impact on firm value, I believe that using a similar set of data gathering and statistical techniques and variables such as the ones referenced would prove out my hypotheses.


Literature Review

A review of existing literature confirms that tax planning in general increases firm value.  When a firm reduces its tax expense, it earns a higher return and creates more wealth for its owners.  For example, Bryant-Kutcher et al. (2012) found that firms with lower foreign effective tax rates have a higher firm value.  Further, Goh et al (2016) found that cost of equity is lower for tax-avoiding firms thereby reducing a firm’s expense and contributing more to profitability.  This effect is stronger for firms with better outside monitoring, firms that realize higher marginal benefits from tax savings, and firms with higher information quality.  Goh’s et al (2016) results suggest that equity investors generally require a lower expected rate of return due to the positive cash flow effects of corporate tax avoidance.

A mediator in the relationship of tax planning and firm value is firm governance whereby well governed firms have better results with tax planning than other firms.  Wilson (2009) found that tax shelter firms with strong corporate governance exhibited significant positive abnormal returns during the period of active tax shelter participation.  These results were consistent with tax sheltering being associated with wealth creation for shareholders in firms with strong corporate governance.  Desai and Dharmapala (2009) go even further.  They contend that the simple presumption that corporate tax avoidance represents a transfer of value from the state to shareholders does not appear to be validated in the data.  Rather, they argue that the patterns in the data are more consistent with the agency perspective on corporate tax avoidance, which emphasizes the mediating role of governance.  They found that the basic result that higher-quality firm governance leads to a larger effect of tax avoidance on firm value is reinforced by using an exogenous source of variation due to changes in tax regulations to construct instrumental variables for tax avoidance activity.

In addition, tax directors and other executives tend to be rewarded when they keep certain measures of the companies’ tax burden low.  Desai and Dharmapala (2006) found that incentive compensation appears to be a significant determinant of tax avoidance activity.  In particular, they found that higher-powered incentives are associated with lower levels of tax sheltering.  Similarly, Armstrong et al (2012) found that tax directors’ compensation is correlated with the GAAP effective tax rate but they did not find that tax directors’ compensation is correlated with the cash effective tax rate, that tax directors are compensated for being overly tax aggressive, or that other executives’ pay is correlated with tax planning.

The existing literature also shows that firms will balance tax aggressiveness with reputational risks associated with tax audits and litigation.  Austin and Wilson (2017) found that firms with valuable brands will engage in less tax avoidance.  Specifically, they found that there is a positive and significant association between the measure of reputation and both the GAAP and cash effective tax rates, but there is mixed evidence on whether there is a negative and significant association between reputation and the probability the firm is engaging in tax sheltering.  Graham et al (2014) found that reputational concerns are important.  In response to a survey, 69% of executives rated reputation as important and it ranks second in order of importance among all factors explaining why firms do not adopt a potential tax planning strategy.  Graham et al (2014) also found that financial accounting incentives play a role.  For example, 84% of publicly traded firms responded in a survey that top management at their company cares at least as much about the GAAP effective tax rate as they did about cash taxes paid and 57% of public firms said that increasing earnings per share is an important outcome from a tax planning strategy.  Moreover, Hanlon and Slemrod (2009) found that a company’s stock price declines when there is news about its involvement in tax shelters.  This stock price decline is more negative for firms in the retail sector, suggesting that part of the reaction may be a consumer/taxpayer backlash.  The reaction seems to be less negative for firms with a higher cash effective tax rate, consistent with the market interpreting the news as a positive signal of tax aggressiveness.

However, all of these studies are geared toward tax planning in the aggregate.  Corporations undertake a variety of tax planning activities – at the international level, federal level, and state and local level.  The articles referenced above support the fact that aggressive tax planning, in general, has a positive impact on firm value because the tax savings represents a higher return for investors.  The authors do not attempt to separate out the impacts of state, federal or international tax planning.  Many multinational firms who engage in aggressive international tax planning may not bother with state tax planning because the potential savings may be minor and would not justify the effort.  There are also firms that engage in a combination of aggressive federal, state and international tax planning and their value would certainly be positively impacted from the aggregate effect of the combined tax planning as the articles indicate.  Then there are primarily domestic firms that do not have the opportunity to engage in much federal or international tax planning, and focus their efforts instead on state tax planning.

The purpose of this research proposal would be to identify the impact of multistate tax planning on firm value.  The answer to the research question will provide guidance to corporations in determining whether aggressive multistate tax planning has an impact on their stock price and, thus, whether it is a worthwhile endeavor.


Methods Section

State tax planning comes in many different forms.  One of the more common forms is a firm choosing what states to set up operations.  For example, a company may choose to set up its operations in a low tax or no tax state(s).  Other forms of state tax planning include creating a legal entity structure with a parent company and operating subsidiaries.  Roughly half of the states will respect separate legal entities, the other half force related companies to file as a unitary group.

In the parent/subsidiary structure, a firm can set up a series of payments and deductions between the different entities to minimize state taxes.  For example, the parent could choose to be headquartered in a state without a corporate income tax (such as Ohio) and create operating subsidiaries in the other states.  The parent could charge the subsidiaries a substantial fee for providing various administrative services to the subsidiary companies, such as financial services, human resource services, research and development services, etc.  All the income would be funneled to the state without a corporate income tax (such as Ohio) and the operating subsidiaries in the other states would get a large deduction thereby reducing state income taxes.  Thus, in the states that recognize separate legal entities, the firm has significantly reduced its taxable income and as a direct result, its state and local income tax liability.  From a federal tax standpoint, the transactions are a wash because the entities likely file a consolidated federal tax return that disregards the parent/subsidiary structure.  So, the structure does not draw any Internal Revenue Service scrutiny.

Another way that firms can minimize their state and local income taxes is by taking advantage of state specific tax incentives.  For example, the state of New York permitted companies engaged in “manufacturing” to pay tax at a 0% rate.  Also, states sometimes offer lucrative tax incentives to entice specific companies to set up operations in the state.  Recently, the state of New York offered Amazon significant tax breaks if it would move its headquarters there.  In the face of public backlash, though, New York later rescinded this offer.

As all U.S.-based companies must operate in at least one state, all U.S.-based companies are capable of state tax planning.  In their audited financial statements, companies are required to reconcile their statutory income tax rate to their effective income tax rate.  In making this reconciliation, corporations will usually list their state and local effective tax rate (SETR) in the tax footnote to the financial statements.  This SETR will serve as a good proxy for effectiveness of a firm’s state tax planning.

Tobin’s Q is often seen as a good indicator of firm value.  The Tobin’s Q ratio equals the market value of a company divided by its assets’ replacement cost.  Thus, equilibrium is when market value equals replacement cost (Tobin’s Q equals 1).  If the market value is less than the replacement cost (Tobin’s Q is between 0 and 1) and the firm is seen as undervalued.  If the market value is greater than the replacement costs (Tobin’s Q is greater than 1) and the firm is seen as overvalued.  There are different methodologies people use to calculate Tobin’s Q.  For purposes of this study, Tobin’s Q was used as an indicator of firm value.  Rather than evaluate the merits of the different computational methodologies and try to assemble the various data needed to compute Tobin’s Q, a precalculated Tobin’s Q was obtained from YCharts investment data service.

A random sample of fifty large, publicly traded U.S. companies was selected.  SETR for 2018 was found by looking at the tax footnote to the company’s audited financial statements in the Annual Report (Form 10-K).  Tobin’s Q for fourth quarter 2018 was found using the YCharts investment service.  The relationship between firm value and SETR was determined using a regression analysis.  The list of companies in the study, together with the SETR and Tobin’s Q are listed in Appendix A.  The regression output is listed in Exhibit B.  The regression analysis confirmed the hypothesis that a lower SETR has an impact on firm value at a p-value of 0.11.  That is, for every one percentage point the SETR increases, the Tobin’s Q drops by 0.26.  The p-value is high at 0.11, but Tobin’s Q is simply one measure of firm value.  Given time and additional data, the model could be further refined, and I would expect the p-value to drop.

I believe this model could be expanded and enhanced based on work that has already been done.  Other independent variables that could be included in the model are return on assets, market capitalization, capital assets, degree of leverage, cash flow, firm size, net operating losses (NOLs), and possibly others.  Though it is possible that I may need to add or remove variables.  Further, data from additional years should be included in the study, perhaps five to ten years.  My desired sample size would be between 500-2,000 firms.  I would also like to test for whether corporate governance and reputation are moderators in the model.





Armstrong, C.S., Blouin, J.L., Larcker, D.F. 2012.  The Incentives for Tax Planning.  Journal of Accounting and Economics, 53, 391-411.


Austin, C.R., Wilson, R.J. 2017.  An Examination of Reputational Costs and Tax Avoidance: Evidence from Firms with Valuable Consumer Brands. The Journal of the American Taxation Association 39, 67-93.


Bryant-Kutcher, L.A., Guenther, D.A., Jackson, M.  2012.  How Do Cross-Country Differences in Corporate Tax Rates Affect Firm Value?  The Journal of the American Taxation Association, 34, 1-17.


Desai, M.A., Dharmapala, D. 2006.  Corporate Tax Avoidance and High Powered Incentives.  Journal of Financial Economics, 79, 145-179.


Desai, M.A., Dharmapala, D. 2009.  Corporate Tax Avoidance and Firm Value.  Review of Economics and Statistics, 91, 537-546.


Goh, B.W., Lee, J., Lim, C.Y., Shevlin, T.  2016.  The Effect of Corporate Tax Avoidance on the Cost of Equity.  The Accounting Review, 91, 1647-1670.


Graham, J.R., Hanlon, M., Shevlin, T., Shroff, N.  2014.  Incentives for Tax Planning and Avoidance: Evidence from the Field. The Accounting Review, 89, 991-1023.


Gupta, S., Mills, L.F. 2002.  Corporate Multistate Tax Planning: benefits of multiple jurisdictions.  Journal of Accounting and Economics, 33, 117-139.