The Senate Permanent Subcommittee on Investigations recently released a report claiming that Caterpillar, the maker of industrial equipment, “avoided or deferred $2.4 billion in U.S. taxes over a 13-year period by shifting profits to a Swiss affiliate.” According to the report, prior to 1999, the majority of the company’s profits were booked from replacement part sales to non-U.S. customers in the United States, while after 1999, 85% or more of those profits shifted to the Swiss unit.
As reported in The New York Times, Caterpillar defended the company's decision and explained that Caterpillar U.S. was "an unnecessary middleman" in the Swiss affiliate's operations, which caused the company to incur "unnecessary expenses” and that the restructuring after 1999 was "prudent, lawful business planning.”
In a similar scenario also reported in The New York Times, just last month drug manufacturer Pfizer proposed a $99 billion acquisition of AstraZeneca, which would allow it to reincorporate in Britain, avoid the U.S. corporate tax rate, and save billions of dollars each year. Although the deal may not come to fruition, it still points to the fact that Pfizer is following many other large American companies that are looking for ways to lower their tax bill.
So who is behind these decisions? And is there a clear line between playing the tax game by the rules and flat out cheating? More specifically, to what extent do top executives play a role in shaping a firm’s tax avoidance strategy?
The Executive Influence
In “The Effects of Executives of Corporate Tax Avoidance”, Michelle Hanlon, Professor of Accounting at MIT Sloan, and her research partners studied 908 executives across corporate firms over time in order to identify executive effects on tax rates. In the study, Hanlon defines tax avoidance as “anything that reduces the firm’s taxes relative to its pretax accounting income.” In order to fairly track executive influence, the study focused on executives’ roles in their career among several firms, tracking their progress every time they switched firms.
According to Hanlon, results indicate that individual executives play a significant role in determining the level of corporate tax avoidance that firms undertake. Furthermore, there is a large economic impact determined by the executive effect on tax avoidance. Says Hanlon, “Moving between the top and bottom quartiles of executives results in approximately an 11% swing in GAAP effective tax rates; thus, executive effects appear to be an important determinant in a firm’s tax avoidance.”
At first glance, it’s hard to imagine that one executive—even the CEO—could influence an entire corporation’s tax avoidance strategy to such a significant amount that it arouses suspicion or the need for government-funded research studies. But, as Hanlon notes, a CEO can affect tax avoidance by setting the tone at the top with regard to the firm’s tax activities. For example, some CEOs may change the relative emphasis of different functional areas of the firm such as marketing, operations, or treasury that directly affect the tax structure.
The study confirmed that there is measurable pressure exerted from top executives on the tax director, and this pressure can influence the tax avoidance strategy to the firm’s detriment. Hanlon gives the example of David Bullington, Wal-Mart’s former Vice President for tax policy (now at JCPenny), who stated in a North Carolina deposition that he began to feel pressure to lower the company’s effective tax rate after the current chief financial officer, Thomas Schoewe, was hired in 2000. Said Bullington, “Schoewe was familiar with some very aggressive tax planning ... and he rides herds [sic] on us all the time that we have the world’s highest tax rate of any major company.”
The finding of Hanlon and her colleagues raise many questions that can hopefully be addressed by future research. What happens to these executives and the firms they manage? Do executives who appear to emphasize tax avoidance lead their firms to take on substantial tax risk? Will they see additional audits and taxes, perhaps on another executive’s watch? What happens to the career prospects of executives who emphasize or de-emphasize tax avoidance? In addition, future research could examine whether tax avoidance indicates anything about the executives’ propensity to emphasize other behavior that may be dangerous to the company.
Michelle Hanlon is a Professor of Accounting at MIT Sloan School of Management and teaches in the Strategic Cost Analysis for Managers program at MIT Sloan Executive Education.