Each year, the majority of public companies in the United States pay 20 to 40 percent of pretax income to the government in the form of income taxes. Since every dollar paid to Uncle Sam is a dollar that cannot be reinvested within an organization, paying taxes could be considered an inefficient utilization of resources.
Recognizing this inefficiency, managers and shareholders alike are interested in tax minimization strategies. Previous studies have generally examined corporate tax planning as a function of firm-level characteristics such as the location of foreign operations, investments in R&D, and capital expenditures, all of which provide companies with valuable tax benefits. However, a recent study from Georgetown's McDonough School of Business investigates the influence and impact of individual managers on corporate tax strategies.
In the study, Does operational efficiency spill over onto the tax return?, Assistant Professor Allison Koester and her co-authors find that managers with greater ability to efficiently utilize firm resources for revenue-generating purposes engage in greater tax planning. Using data from more than 7,800 U.S. public companies and their management teams over the period from 1994 to 2010, Koester found managers are better able to structure their R&D activities, capital expenditures, and foreign operations more tax-efficiently than their lower ability industry peers. Whether they possess tax-specific expertise or hire external consultants for help, high ability managers can efficiently reduce cash outflows to taxing authorities -– saving their firm money without interfering with operations. The combined federal and state statutory corporate tax rates are currently about 42 percent. Based on the managerial ability metric Koester uses in her study, she finds that the top 10 percent of management teams pay taxes at a rate of only 25 percent of their firms’ pretax income. The average pretax income for these companies is $211 million, which translates to more than $35 million in annual tax savings.
“In an effort to pay less in taxes, which frees up resources to either invest internally or return capital to shareholders, organizations are looking for executives who are skilled in effective tax planning,” said Koester. “Our study is the first to document a causal relation between successful tax planning and a manager’s ability to efficiently utilize inputs to maximize outputs.”
To further test the study’s findings, Koester examined changes in tax planning around CEO turnovers. When a low ability CEO is replaced with a high ability CEO, firms experience more than a three percent decline in cash-based effective tax rates during the three years following the turnover (relative to the three years prior to the change in leadership).
In sum, managerial ability affects both the efficiency of firm operations and the firm’s ability to achieve significant tax savings. By understanding that managerial ability is a significant determinant of corporate tax planning, board members can quantify the benefits of hiring executives who can align tax and business strategies.