Today's wired world has most of us drowning in information. Twenty-four-hour cable news networks, instantaneous online updates, Facebook, and Twitter are constantly assaulting our senses. Much of what passes for "news" is really just noise — the latest statistical fluctuations in the presidential polls, for example, or the comings and goings of your favorite Kardashian sister. But every so often, we learn something so surprising that it rocks us to the core and causes us to re-evaluate everything we thought we knew.
Three professors have just revealed that sort of earth-shattering information in the newest issue of Accounting Review. They analyzed data from 5,000 corporations over 17 years from 1992-2008 to answer an age-old question: "Do IRS Audits Deter Corporate Tax Avoidance?" And here's their startling conclusion -- make sure you're sitting down to read it: when audit rates go up, so do taxes!
"We extend research on the determinants of corporate tax avoidance to include the role of Internal Revenue Service (IRS) monitoring. Our evidence from large samples implies that U.S. public firms undertake less aggressive tax positions when tax enforcement is stricter. Reflecting its first-order economic impact on firms, our coefficient estimates imply that raising the probability of an IRS audit from 19 percent (the 25th percentile in our data) to 37 percent (the 75th percentile) increases their cash effective tax rates, on average, by nearly 2 percentage points, which amounts to a 7 percent increase in cash effective tax rates. These results are robust to controlling for firm size and time, which determine our primary proxy for IRS enforcement, in different ways; specifying several alternative dependent and test variables; and confronting potential endogeneity with instrumental variables and panel data estimations, among other techniques."
Shocking, isn't it? (Just FYI, "endogeneity" is a statistical condition that occurs when there's a correlation between a parameter or variable and an "error term." It can arise as a result of measurement error, or a few other things that require looking up, including autoregression with autocorrelated errors, simultaneity, omitted variables, or sample selection errors.)
Let's give the authors a little credit here — they do say it's not really surprising that more audits equal more taxes. But they say it was hardly obvious before they started their study. What if they found that corporations were just so confident they could outmaneuver the IRS that audit rates didn't matter?
The professors also argue that shareholders benefit from IRS audits — especially when corporate governance is weak. Co-author Jeffrey Hoopes of the University of Michigan reports that "strict tax enforcement promotes good financial reporting and tends to check managers' proclivities to divert corporate resources for their personal use under the guise of saving taxes.” They cite Tyco as an example, where top executives minimized taxes by relocating profits to low-tax foreign countries, then diverted millions of dollars for their own personal use. (Remember CEO Dennis Kozlowski, who spent $15,000 of shareholder money on an umbrella stand? Yeah, that guy . . . he's in jail now.)
What does all this mean for you? Well, audit rates for personal returns average just over one percent. That's a tiny fraction of the 30% or so that the biggest group of companies in the Accounting Review study faced. But I file every return as if I expect it to be audited. Yes, I work and plan to minimize your taxes. But the strategies I use are all court-tested and IRS-approved. That way, you save money and sleep well at night!
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