One of the mysteries of corporate tax behavior is why companies don’t always do everything they can to avoid taxes. University of Chicago’s David Weisbach helped to identify this phenomenon, which is sometimes described as the “undersheltering puzzle.” This conundrum may come as a surprise to those who noticed that Amazon, Netflix, General Motors, and at least 57 other Fortune 500 companies didn’t pay a cent in US income tax last year on a combined $79 billion of profits, according to the Institute on Taxation and Economic Policy. But as Weisbach has put it, “It is not clear, given the wide variety of shelters, why any business pays tax at all.”

Using a model to explore how a business might strategically employ various tax-avoidance methods, Chicago Booth’s Charles McClure finds that trying to squeeze every possible penny out of Uncle Sam just costs too much for most companies.

One important factor is an official interpretation of US accounting rules known as FIN 48. Effective since late 2006, the interpretation means American companies have to analyze and disclose the risks of their decisions regarding federal taxes. The benefit of any tax-planning maneuver that is sufficiently likely to be overturned if it were examined by authorities must be recorded as a liability until its risk of being overturned has passed—which means that benefit won’t immediately be reflected in reported earnings. The rule, developed by the Financial Accounting Standards Board, has had a pronounced effect on businesses’ behavior, McClure finds.

Based on a sample of 2,583 companies with an average market cap of $7.4 billion, his model demonstrates that between 2007 and 2016, the disclosures required under FIN 48 had the effect of increasing corporate tax payment rates by 2.8 percent. This boosted the average company’s remittances by $27.3 million, compared with alternate scenarios under which businesses immediately captured all potential tax savings on their income.

McClure started from the assumption that companies need to balance maximizing reported earnings and minimizing tax payments. Financial-reporting incentives are integral to tax planning, but it’s difficult to isolate their effects from other competing factors. To do so, McClure focused on reporting of uncertain tax benefits—those that might be overturned in a future audit—which affect net income but not current tax payments.

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Although tax avoidance can lower tax payments and increase after-tax cash flows, companies must weigh this benefit against three costs, McClure writes. First, riskier strategies carry smaller financial-reporting benefits, since the tax advantages can’t be recognized right away. Second, tax avoidance can impose operational frictions that lower pretax income—for instance, aggressive tax planning may create reputational concerns that could be expensive to mitigate. McClure finds such nontax costs decreased pretax earnings by an average of 7.4 percent, or $65 million. The final cost is a greater probability of audits and inspections resulting from risky tax strategies.

McClure’s model takes these factors into account. His findings suggest that companies have significantly adjusted their tax strategies to comply with FIN 48, with negligible impact on corporate value. This is consistent with the market’s blasé reaction to the original announcement of FIN 48.

McClure also provides an analysis of how the Tax Cuts and Jobs Act of 2017 affects the tax-avoidance dynamic, predicting that the lower corporate rate of 21 percent will reduce companies’ incentive to pursue creative accounting techniques.

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