How Do Firms Respond to Corporate Taxes?

• Published date: 01 June 2022
• Author: JEFFREY L. COLES,ELENA PATEL,NATHAN SEEGERT,MATTHEW SMITH
• Date: 01 June 2022
• DOI: http://doi.org/10.1111/1475-679X.12405

DOI: 10.1111/1475-679X.12405

Journal of Accounting Research

Vol. 60 No. 3 June 2022

Printed in U.S.A.

How Do Firms Respond to

Corporate Taxes?

JEFFREY L. COLES,∗ELENA PATEL,∗NATHAN SEEGERT,∗

AND MATTHEW SMITH†

Received 15 November 2019; accepted 3 July 2021

ABSTRACT

Using a novel empirical approach and newly available administrative data on

U.S. tax filings, we estimate the corporate elasticity of taxable income, de-

compose the elasticity into economic responses versus other tax-motivated

“accounting” transactions, and determine how responsiveness varies depend-

ing on accounting method, firm size, and interest rate. In response to a 10%

increase in the expected marginal tax rate, private U.S. firms decrease taxable

income by 9.1%, which indicates a discernibly more elastic response than pre-

vailing estimates. This response reflects a decrease in taxable income of 3.0%

arising from real economic responses to a firm’s scale of operations and 6.1%

arising from accounting transactions via (for example) revenue and expense

timing. Responsiveness to the corporate tax rate is more elastic if a firm uses

cash (9.9%) rather than accrual accounting (7.4%), if the firm is small (9.9%)

rather than large (8.6%), and if the firm discounts future cash flows at a lower

rate.

∗Department of Finance, University of Utah; †U.S. Treasury Department

Accepted by Rodrigo Verdi. We are grateful for constructive, insightful comments from

the editor, associate editor, and referee. We thank Pankaj Jain (FMA 2021 discussant) and

participants from the National Tax Association Annual Conference on Taxation, the Oxford

University Centre for Business Taxation Annual Symposium, the 2021 Annual Meeting of the

Financial Management Association, the Office of Tax Analysis, the Federal Reserve Board of

Governors, and the University of Oregon Department of Economics. Disclaimer: The views

expressed in this paper are those of the authors and do not necessarily represent the views

of the U.S. Treasury Department. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting- research/online-supplements

965

© 2021 The Chookaszian Accounting Research Center at the University of Chicago Booth School of

Business.

966 j. l. coles, e. patel, n. seegert, and m. smith

JEL codes: G32, G30, G38, H25, H21, H26, L25, L33, M40, M41

Keywords: corporate elasticity of taxable income; private firm behavior;

corporate tax; investment; tax reporting

1. Introduction

The consequences of the corporate tax system for corporate behavior rep-

resent a persistent and energetic area of inquiry. Prior literature examines

a variety of matters, including the effects of corporate taxes on capital struc-

ture (see the survey of Graham and Mills [2008], also Lemmon, Roberts,

and Zender [2008]), investor trading and stock prices (Seyhun and Skin-

ner [1994]), earnings management (Blouin, Core, and Guay [2010a]), re-

search and development effort (Berger [1993] and successors), organiza-

tion form (Scholes et al. [2009]), the lease or buy decision (e.g., Graham,

Lemmon, and Schallheim [1998]), whether to reinvest or repatriate earn-

ings (Newberry and Dhaliwal [2001], Blouin and Krull [2009]), and tax

director and management incentives (Desai and Dharmapala [2006], Arm-

strong et al. [2009]).1We advance this literature by using new data and im-

proved methods to assess how responsive public and private corporations

are to the corporate income tax rate and to measure the components of

that responsiveness.

To briefly summarize, we (1) estimate the corporate elasticity of taxable

income (the CETI), (2) decompose this elasticity into real versus account-

ing responses, and (3) further investigate these mechanisms by leverag-

ing cross-sectional variation in accounting method, firm size, and interest

rates. To enable our analysis we (1) implement methodological advances

in econometric bunching methods (Chetty [2009], Blomquist and Selin

[2010], Saez [2010], Bertanha, Mccallum, and Seegert [2016]) and (2) de-

ploy a novel administrative data set containing the universe of 1.5 million

tax returns provided by the U.S. Internal Revenue Service (IRS). These

data allow us, as a fourth contribution, to provide evidence on the behav-

ior of private firms, which make up 99% of all corporations but are often

excluded from examination because of lack of data.

First, we find that U.S. firms reduce taxable income by 8.9% at the tax

schedule’s first tax bracket threshold, which corresponds to a CETI of 0.91.

In other words, firms reduce their taxable income by 9.1% in response to a

10% change in the net of tax rate.2This finding indicates a much stronger

1The surveys of Shackelford and Shevlin [2001], Hanlon and Heitzman [2010], Graham

[2013], and Dyreng and Maydew [2017] summarize these and other studies of the effects of

taxes on corporate decisions.

2The CETI in the tax rate, without specifying the specific components, aggregates a broad

spectrum of observable and unobservable responses of firms. The responses include, but are

not limited to, the mechanisms mentioned above that have been previously explored in the

literature.

how do firms respond to corporate taxes? 967

corporate response to changes in the corporate tax that is more than four

times the estimates of the U.S. CETI reported in prior literature. The dif-

ference matters because an accurate, defensible measure of the CETI is

essential in estimating the effect of tax changes on business activity, includ-

ing output, revenue, costs, investment, profits, employment, labor incomes,

taxable income, and tax revenue. Accordingly, the CETI also is used to as-

sess the distortionary costs of the corporate tax system—costs that arise be-

cause the choices of firms are distorted by taxes away from those that would

otherwise reflect actual economic costs and benefits. For these and other

reasons the CETI is a primary input in the formation of tax policy.

Second, we find that 67% of firms’ response is because of accounting

transactions, and the other 33% is because of economic responses. When

firms face higher corporate tax rates, they have an incentive to change

the scale of the enterprise by reducing production, investing less, engag-

ing fewer employees, and reducing other input usage. We refer to these

types of responses as economic responses. When firms face a change in tax

rate, whether driven by the progressive corporate tax schedule or statutory

changes in tax rates, they also have an incentive to shift income across time,

jurisdictions, types of income, and types of entities to reduce taxable in-

come. We refer to these types of responses as accounting responses.3Exam-

ples of accounting responses include intertemporal income shifting where

firms can shift income into future periods by accelerating expenses or de-

ferring revenue in anticipation of future lower tax rates. For example, firms

that employ cash accounting can move up expenses by immediately paying

bills and prepaying invoices and can try to postpone revenue by delaying in-

voicing. Alternatively, accrual accounting firms can accelerate expenses by

accurately estimating and fixing the liability for the expense in the current

year, so long as economic performance and revenue also are accelerated.

An accruals-accounting firm could also defer revenue by delaying the occur-

rence of one or more of the events that determine the taxpayer’s right to

receive the revenue, such as by delaying shipments of goods so that title has

not passed at year-end. Whether firm behavior is dominated by economic

responses or accounting responses has similar implications for tax revenues

but different implications for tax reporting, tax enforcement, and the real

effects and distortions in the economy arising from the tax system.

Third, we find that cash accounting firms respond more than accrual

firms, and small firms are at least as responsive as large firms. We argue that

firms of different sizes and with different accounting methods use different

methods to respond to the corporate tax rate, including differences in eco-

nomic and accounting responses. For example, large firms potentially have

more channels to shift income, such as by way of transfer pricing across

business units and jurisdictions. Alternatively, large firms can be less willing

3Although the terminology is imperfect, accounting responsiveness refers to these and

other avoidance actions, including timing nonrecurring transactions, misreporting, and other

avoidance and evasion tactics.