Do managers respond to tax avoidance incentives by investing in the tax function? Evidence from tax departments

Abstract

While prior literature examines the role of certain incentives in motivating top managers (CEOs and CFOs) to engage in corporate tax avoidance, there is little evidence on the specific actions that managers take in response to these incentives. Motivated by the premise that a manager can influence a firm’s tax activities by directing resources towards the tax function, I investigate whether four specific tax avoidance incentives studied in prior literature (financial constraints, equity risk incentives, hedge fund interventions, and analyst cash flow forecasts) induce managers to make investments in hiring personnel within the firm’s tax department. Using a dataset of tax department employees collected from the professional networking website LinkedIn, I find evidence that each incentive is significantly associated with an increase in the number of individuals employed within the tax department. This association is generally stronger among higher ranked employees and employees with prior tax department experience. Overall, my findings are consistent with the premise that managers invest resources in the tax function when they are incentivized to avoid taxes. My study also provides some assurance that the association between tax avoidance incentives and effective tax rates documented in prior studies is reflective of intentional tax avoidance behavior.