The Changing Role of Auditors in Corporate Tax Planning

This paper examines changes in the role that auditors play in corporate tax planning following recent events, including the well-known accounting scandals, passage of the Sarbanes-Oxley Act, and regulatory actions by the SEC and PCAOB. On the whole, these events have increased the sensitivity to and scrutiny of auditor independence. We examine the effects of these events on the market for tax planning, in particular the longstanding link between audit and tax services. While the effects are recent, they are already being seen in the data. Specifically, there has already been a dramatic shift in the market for tax planning away from obtaining tax planning services from one's auditor. We estimate that the ratio of tax fees to audit fees paid to the auditors of firms in the S&P 500 decline from approximately one in 2001 to one-fourth in 2004. At the same time, we find no evidence of a general decline in spending for tax services. In sum, the evidence indicates a decoupling of the longstanding link between audit and tax services, such that firms are shifting their purchase of tax services away from their auditor and towards other providers.

A Unifying Model of How the Tax System and Generally Accepted Accounting Principles Affect Corporate Behavior

This paper models the impact of the tax system and GAAP on the real and financial reporting decisions of corporations. It provides a first step toward joint evaluation of taxation and financial reporting in the standard economic analyses of corporate behavior. The key finding is that value arises from real decisions that provide firms with discretion in their tax and financial reporting. This desire for flexibility modifies the optimal decisions of firms, in theory, and we provide examples that illustrate this behavior in the real world.

Did Dividends Increase Immediately After the 2003 Reduction in Tax Rates?

The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduces the maximum statutory personal tax rate on dividends from 38.1 percent to 15 percent. This study analyzes dividend declarations in the quarter following passage. Aggregate dividends rose by 9 percent when boards of directors first met following enactment. Consistent with the dividend changes being tax-motivated, they are increasing in the percentage of the firm held by individuals. Dividend changes also increased with insider ownership, consistent with managers acting in their own interests. However, these results are limited primarily to firms that made large, special dividends. We find little evidence of an increase in regular, quarterly dividend payments.

Did Firms Substitute Dividends for Share Repurchases after the 2003 Reductions in Shareholder Tax Rates?

This paper tests whether firms altered their dividend and share repurchase policies in response to the 2003 reductions in shareholder tax rates. We predict that firms substituted dividends for repurchases, because the reduction in dividend tax rates exceeded the reduction in the capital gains tax rates. As expected, we find substitution and find that it is increasing in the percentage of the company owned by individual investors, the only shareholders affected by the legislation. These findings are consistent with boards of directors considering the tax preferences of individual stockholders (particularly officers and managers) when setting dividend and share repurchase policies.

Capital Gains Taxes and Stock Reactions to Quarterly Earnings Announcements

This paper examines the impact of capital gains taxes on equity pricing. Examining three-day cumulative abnormal returns for quarterly earning announcements from 1983-1997, we present evidence consistent with shareholders' capital gains taxes affecting stock price responses. To our knowledge, this is the first study to link shareholder taxes and share price responses to earnings releases. The results imply that shares trade at higher (lower) prices when individual investors face incremental taxes (tax savings) created by selling appreciated (depreciated) shares before they qualify for long-term treatment. Unlike prior studies that have focused on price reactions in settings where shareholder taxes are unusually salient (e.g., tax law changes, turn-of-the-year trading, or tax-sensitive transactions), this study finds the imprint of capital gains taxes in a more general setting.

Capital Gains Taxes and Asset Prices: Capitalization or Lock-In?

This paper examines the impact on asset prices from a reduction in the long-term capital gains tax rate using an equilibrium approach that considers both demand and supply responses. We demonstrate that the equilibrium impact of capital gains taxes reflects both the capitalization effect (i.e., capital gains taxes decrease demand) and the lock-in effect (i.e., capital gains taxes decrease supply). Depending on time periods and stock characteristics, either effect may dominate. Using the Taxpayer Relief Act of 1997 as our event, we find evidence supporting a dominant capitalization effect in the week following news that sharply increased the probability of a reduction in the capital gains tax rate and a dominant lock-in effect in the week after the rate reduction became effective. Nondividend paying stocks (whose shareholders only face capital gains taxes) experience higher average returns during the week the capitalization effect dominates and stocks with large embedded capital gains and high tax sensitive investor ownership exhibit lower average returns during the week the lock-in effect dominates. We also find that the tax cut increases the trading volume during the week immediately before and after the tax cut becomes effective and in stocks with large embedded capital gains and high tax sensitive ownership during the dominant lock-in week.