Evidence That the Securities Markets Perceive Changes in Effective Tax Rates as Placing a Higher Burden on High-Growth Firms Than Low-Growth Firms

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In this study, we test whether the securities markets perceive changes in effective tax rates as being fair across high- and low-growth firms. In those years surrounding major tax legislation (1981-1982, 1986-1987, and 1990-1992), we find that the market perceived increases in effective tax rates as taxing high-growth firms to the extent that their expected rate of growth will suffer. We find no such evidence for low-growth firms, however, suggesting that the government properly calibrates tax increases for low-growth firms, but may overestimate the degree to which high-growth firms will alter their contracting environment to avoid higher taxation. With reductions in effective tax rates, we find that the 1981 and 1986 Acts were perceived as stimulating growth for all firms, but the acts of the early 1990s were perceived as stimulating growth only for low-growth firms. The R&D tax credits granted by the acts of the early 1990s may be an example of tax relief that was likely targeted to a specific class of taxpayer (high growth, in this case) that is exploited by other non-targeted classes.


Researchers typically assume that a firm is a nexus of contracts designed to efficiently arrange transactions (Coase, 1988; Milgrom & Roberts, 1992). When tax laws change, however, the contracting environment is altered, compelling firms to negotiate new "contracts" or renegotiate existing "contracts." These changes in contracting arrangements arise from attempts to exploit new tax incentives that lower a firm's effective tax rate or from attempts to mitigate the effects of new tax increases that raise a firm's effective tax rate. The extent to which a firm can successfully negotiate or renegotiate these contracts depends on a firm's tax-planning flexibility.

Prior empirical research on tax-planning flexibility has been limited to examining whether taxpayers respond to tax law changes by shifting reported earnings into the more favorable taxing period (pre- or post-enactment). Guenther (1994), for instance, shows that firms managed accruals in response to the tax law changes of 1986. These one-time shifts in reported earnings were designed either to exploit tax loopholes that would be closed by the end of 1986 or to exploit tax incentives that became effective in 1987. While the timing of earnings recognition may be easily managed by a broad cross-section of firms, the flexibility to favorably negotiate new contracts or to renegotiate existing contracts in light of new tax legislation is likely to vary significantly across firms.

The ability to favorably negotiate new contracts (and possibly renegotiate existing contracts) should be most easily accomplished by firms experiencing high growth. Such firms are engaging in new business where the terms of trade are yet to be determined. These firms would thus have the greatest flexibility in structuring their future contracts. This flexibility in structuring future contracts affords high-growth firms greater opportunities to pursue those tax planning strategies that would exploit the provisions of the new tax laws. In the short-run (the phase-in period provided by many statutory changes) tax planning strategies are likely to be limited to modifying the firm's investment and financing positions in order to exploit any loopholes or incentives in the new statute. In the long-run, tax planning strategies are likely to be more flexible, allowing a firm to increase the level of debt, exercise options to purchase leased assets, exploit any 'grandfather' provisions or exercise provisions in existing contracts that allow for renegotiation, among others.

The Federal Government typically amends the Federal tax code in an attempt to achieve some policy objective. It targets specific classes of taxpayers and either lowers taxes by providing tax incentives and rate reductions, or raises taxes by eliminating incentives, raising rates or identifying sources of additional revenue. …


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