BLOOMINGTON, Ind. – Companies’ low effective tax rates have drawn the ire of politicians, policymakers, the media and the public. As Congress begins debating changes to corporate taxes to partially fund a $3.5 trillion budget plan, the Biden administration is raising questions about how much corporations pay in taxes. But new research from the Indiana University Kelley School of Business and research colleagues elsewhere suggests very low effective tax rates often do not reflect high levels of tax avoidance.
Effective tax rates, or ETRs, are a measure of tax expense computed under U.S. Generally Accepted Accounting Principles as a percentage of pretax income. To better understand the scope of potential limitations of ETRs, the researchers created an “adjusted ETR” for nearly 15,800 company-year observations from 3,375 companies between 2008 and 2016 to remove items largely unrelated to tax avoidance.
The researchers defined tax avoidance as tax planning strategies managers use to reduce their company’s explicit tax burdens, such as claiming tax credits and shifting income to low-tax jurisdictions.
The study found that companies often report low ETRs not because of aggressive tax avoidance in the current year but rather because of changes in performance or favorable tax settlements with the IRS.
“Financial statement users often compare tax expense as a percentage of income to the statutory tax rate. When the ratio is lower, some may think the company is engaging in tax shenanigans, but our research finds that is often not the case,” said Bridget Stomberg, associate professor of accounting and a Weimer Faculty Fellow at the Kelley School of Business. “We find that many times, very low ETRs – those below 5% – can be attributed to changes in performance that affect the ETR because of rules under U.S. GAAP.”