ATJ Asian Tax Journal

Asian Tax Journal

Print ISSN 1738-3323 Online ISSN 2733-9270

The Effect of Managerial Overconfidence on the Relation between Financial Constraints and Tax Avoidance

  • Jong-Il Park Chungbuk National University
  • Su－In Kim Chungbuk National University

Asian Tax Journal Vol. 21 No. 2 (2020), pp. 157-204

Abstract

We investigate whether the positive association between financial constraints and tax avoidance, and between managerial overconfidence and tax avoidance, and we also how these constructs interact to influence tax avoidance. Specifically, we examine whether both financial constraints and overconfident CEOs are more likely to engage in tax avoidance activities and whether and how they interact in their decision making on tax avoidance. Overconfidence has been found to be a common personal trait in CEOs that affects their investment decision and financial reporting choices. In that sense, CEO overconfidence plays an important role in various corporate policies and tax strategic decisions. In particular, firms facing increased firm－specific and macroeconomic financial constraints exhibit decreasing cash ETRs (i.e., increased tax planning). Tax avoidance may serve as an effective earnings management tool for companies to meet their earnings target, while alleviating their tax burden. Therefore, overconfident CEOs are more likely to promote tax avoidance when firms facing increased financial constraints will take actions to increase internally generated funds (i.e., cash holdings) via tax planning strategies that reduce firms’ cash tax payments, which may be reflected by lower effective tax rates. For this test, our sample of observations includes KOSPI and KOSDAQ listed firms based on the test variable (dependent variable) from 2002 to 2017 (from 2003 to 2018), thus our final sample 13,453 firm－year observations. We utilize financial constraints measures with various proxies for these six constructs used in the prior research. Following Schrand and Zechman (2012), Ahmed and Duellman (2013) and Kim et al. (2016), we construct two additional CEO overconfidence measures. We also adopt tax avoidance measure, annual cash ETRs, to test our research hypotheses. We document several findings. Consistent with expectations, we find that firms facing increases in financial constraints exhibit increases in cash tax planning. We find that companies with overconfident managers are more likely to engage in tax avoidance activities, relative to firms with non－overconfident managers. We also document an interaction effect showing that firms facing increases in financial constraints are more or less likely to engage in tax avoidance activities when these companies also have overconfident managers, relative to those with non－overconfident managers. Moreover, we find evidence that the positive relation between financial constraints and tax avoidance, as well as between managerial overconfidence and tax avoidance is more pronounced for firms with lower cash holdings levels. In sum, our results suggest that both financial constraints and CEO overconfidence are positively associated with companies’ tax avoidance activities and that such activities should exist or not jointly influenced by firms facing increases in financial constraints and overconfident CEOs’ personality traits. Thus, our results contribute to accounting literature by documenting empirical evidence that both financial constraints and managerial overconfidence and their interaction play no important roles in companies’ tax avoidance behaviors. Our paper also contributes to the growing literature on the determinants of corporate tax avoidance. Furthermore, our study helps investors and regulators understand companies’ decision－making processes with regard to tax avoidance.

Keywords

  • Financial constraints
  • Managerial overconfidence
  • Tax avoidance
  • Cash holdings

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Asian Tax Journal

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