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UNC Kenan-Flagler Business School

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Maydew's research tests the certainty of taxes

9/1/2009

Sometimes less is more, even with corporate tax rates. Edward Maydew’s research suggests that if there were fewer opportunities for tax avoidance, the overall corporate tax rate could be lowered and the United States would collect more corporate tax revenue.

“We have a 35 percent corporate tax rate, but we’re not collecting anything close to 35 percent because we have so many provisions that allow companies to reduce that,” Maydew said.

He is UNC Kenan-Flagler’s David E. Hoffman Distinguished Professor of Accounting and the director of research for the UNC Tax Center.

Get rid of some of the provisions that allow rates to vary significantly across companies, and the standard rate could be cut across the board, he added.

Of course, any suggestion of changes to the tax law engenders resistance from those currently benefiting from the status quo. That has long been a sticking point in getting tax reforms through Congress. But Maydew expects to see at least some technical changes in the very complicated corporate tax structure in the near future.

Maydew, working with Scott Dyreng of Duke University and Michelle Hanlon of MIT, looked at taxes paid over a 10-year period by more than 2,000 companies compared to their pretax accounting earnings. Although the standard corporate rate is 35 percent, the average for Maydew’s team sample was less than 30 percent. About a quarter of the businesses paid less than 20 percent, and nearly 10 percent of the companies paid a rate of less than 10 percent annually.

That study did not examine the reasons for the tax avoidance, and Maydew does not want to imply that the companies did anything improper. Congress crafted provisions in its tax code to encourage certain behaviors. For instance, companies that engage in substantial research and development qualify for a special tax credit that lower their taxes.

“In taxes, there are things that are clearly legal and things that are clearly illegal, and there’s gray area in between,” Maydew said. “The objective of a corporation is to maximize shareholder wealth. If the company can do that by structuring things in a certain way for tax purposes, and if it’s legal, they’ll do it, and they should do it.”

Maydew worked as a CPA before enrolling in graduate school at the University of Iowa. Initially planning to specialize in financial accounting, his career took a different path when a book co-written by Nobel Prize in economics recipient Myron Scholes was released. The authors married tax planning from a legal perspective with economics. “That changed the way I thought,” Maydew said, “and made me interested in tax from a research perspective.”

Years later, he felt very honored to join Scholes as a co-author in subsequent editions of the book.

Some of Maydew’s early research, on the dilemma of state income apportionment, had clear policy implications. His research showed that the way states require companies to allocate their national income across state tax jurisdictions can benefit some states to the detriment of neighboring states. The paper led about 10 states to change their tax laws.

Later, Maydew examined how much firms that committed accounting fraud were willing to pay for earnings that did not exist. By reporting fraudulent accounting earnings, companies appear more robust to investors, which encourages more people to invest, allowing managers to keep their jobs, bonuses and perks. But paying taxes on these made-up earnings expended company cash flow to the government.

“What we found was a lot of the companies kept the tax department in the dark about the fraud,” he said. If the CFO told the tax department not to pay taxes on the entire amount of reported earnings, that would widen the scope of people who knew about the fraud and increase the chances that the company would be caught.

The irony was that once the fraud was uncovered, the companies filed amended tax returns to get refunds from the government.

“It was controversial,” Maydew said. “After our paper came out, there was a bill in Congress to prohibit filing amended returns to get refunds on the fictitious earnings. The bill never passed, and it shouldn’t have. The shareholders of that firm, who were the big losers in the fraud, deserved to get the overpaid taxes back from the government.”

Similarly, many victims of the Madoff investment scandal, who paid taxes on earnings that didn’t exist, are seeking refunds of taxes they paid on the earnings they never ultimately received.

Maydew recently completed a research paper that builds on his long-run tax avoidance research. He followed the career paths of about 900 top executives of companies as they left one firm and joined another. By comparing the tax rate paid at the company before and after the executive left and running a similar comparison at the new company before and after the executive joined, Maydew was able to separate effects of the person from the firm.

“In classical economics, the person running the company doesn’t matter,” Maydew said. “You think a company is the same whether it’s run by Person X or Person Y.”

Instead, his research confirmed discussion with people in practice, that the tone at the top makes a substantial difference, even though the CEO does not get directly involved in tax preparation. The tone underscores the company’s emphasis on tax planning and how much risk it’s willing to take.

“We find that these executives make a huge difference in the taxes that the firms pay,” he said. “If you pay less tax, you have higher profitability.”

Follow-up research might look at what the executives are doing to change the tax rate, whether the change is due to executive aggressiveness or something different.

“There is variation across people and companies and how comfortable they are in the gray area and how aggressive they want to be,” Maydew said. “It’s important to teach, especially with complicated transactions, that a lot of things in tax are just not black or white. It’s also important to research this so we understand the economic consequences of ambiguity in the tax code and attitudes about tax risk.”