Executive compensation incentives influence firms’ conforming tax avoidance, research finds

LAWRENCE — The line between tax avoidance and tax evasion is often very thin.

“Some companies like dancing on that line — like tip-tapping all around it,” said Mehmet Kara, assistant professor of accounting at the University of Kansas.

“What we’re showing is that one unintended consequence of executives’ compensation contract design is lower profits, and this leads to lower taxes paid. But if you’re a shareholder whose only concern is maximizing profits, you’re potentially shooting yourself in the foot, depending on how you’re designing this contract.” Mehmet Kara

His paper titled “Equity incentives and conforming tax avoidance” finds that the risk-incentivizing component of option compensation (i.e., vega) is positively associated with conforming tax avoidance, while value-creation component of option compensation (i.e., delta) is negatively associated with conforming tax avoidance. The paper also shows that the negative association between delta and conforming tax avoidance is predominantly driven by risk aversion rather than value creation.

It appears in Contemporary Accounting Research.

Kara, who co-wrote the paper with Michael Mayberry and Scott Rane of the University of Florida, noted that tax avoidance is a phenomenon that regularly transpires in business.

He said, “Tax evasion is what is illegal — like just willfully breaking the law to minimize the taxes you pay. Whereas tax avoidance is utilizing the law in your favor to minimize your payments. Now, for us individuals, this could be in the form of charitable contributions, for example. But for corporations, there’s a very broad palette of options they can take to avoid taxes.”

Kara focuses on two subgroups of tax avoidance: conforming and nonconforming. Conforming tax avoidance occurs when a company lowers the numbers that it reports to the IRS for tax payment purposes, and in response to that, the numbers shown to shareholders are also lowered. Nonconforming tax avoidance occurs when loopholes are used in such a way that a company reports lower numbers to the IRS while simultaneously not lowering the numbers reported to shareholders.

“The downside to conforming tax avoidance is that while you’re reporting lower income to the IRS and paying less tax, you’re also lowering the numbers you report to shareholders because of the conformity between those two figures. Since everybody wants more profits, this can upset shareholders,” he said.

The researchers based their findings on executive compensation payouts. (Publicly traded companies must reveal their top five highest-paid executives, which in almost all instances includes the CEO, the CFO and the COO.)

“We’re essentially looking at the publicly available compensation information for the CEOs of these companies, constructing our compensation metrics, then tying those metrics for the CEOs back to the financial performance of the firms,” he said.

One factor that kept cropping up within how this data was analyzed was the element of risk.

“Regardless of how risk-loving or risk-seeking an individual might be, a majority of the population is very risk-averse, even people like CEOs,” Kara said. “A part of option compensation can be designed to incentivize risk-taking activities because companies don’t want to play it completely safe.”

He found that portion of option compensation tied to risk leads to higher conforming tax avoidance.

“Conforming tax avoidance is perceived to be risky. Reporting lower numbers to the IRS for tax purposes is inherently risky, but when this conforms with the lower number that you report to your shareholders, the perceived risk increases, which is why we see this association between conforming tax avoidance and this risk metric,” he said.

A native of Trabzon, Turkey, Kara has been with KU since 2019. He primarily focuses on tax research as part of the university’s accounting academic area. He asserts the unifying theme amongst all his work is “what influences people to behave a certain way.”

“It is important to think of not only the direct effects that an executive compensation contract could have but the unintended ones,” Kara said. “If you’re a shareholder of a company, you might want to dig deeper into the compensation contract of your CEO to see how that could influence some of the behavior of the person who is running the company.”

Read this article on the KU News website.