Taxes and Financial Constraints: Evidence from Linguistic Cues

Kelvin K. F. Law; Lillian F. Mills

doi:10.1111/1475-679X.12081

Journal of Accounting Research 2015, 53(4): 777–819

with Lillian F. Mills

Abstract

Using a new measure of financial constraints based on firms’ qualitative disclosures, we find that financially constrained firms—firms that use more negative words in their annual reports—pursue more aggressive tax planning strategies as evidenced by: (1) higher current and future unrecognized tax benefits, (2) lower short- and long-run current and future effective tax rates, (3) increase in tax haven usage for their material operations, and (4) higher proposed audit adjustments from the Internal Revenue Service. We exploit the unexpected closures of local banks as exogenous liquidity shocks to show that firms’ external financial constraints affect their tax avoidance strategies. Overall, the linguistic cues in firms’ qualitative disclosures provide incremental information beyond traditional accounting variables or commonly used effective tax rates to reveal and predict tax aggressiveness, both contemporaneously and in the future.

Cash-strapped companies talk negatively, plan taxes aggressively

Published version Preprint Online appendix

Cite (BibTeX)

@article{law2015taxes,
      author  = {Law, K. K. F. and Mills, L. F.},
      title   = {{Taxes and Financial Constraints: Evidence from Linguistic Cues}},
      journal = {Journal of Accounting Research},
      year    = {2015},
      volume  = {53},
      number  = {4},
      pages   = {777--819},
      doi     = {10.1111/1475-679X.12081}
    }

Key takeaways

Firms that use more negative language about financial constraints are more aggressive tax planners
Linguistic cues in corporate filings predict tax behavior
When cash is tight, firms take more tax risk
Text analysis reveals information that financial ratios miss
Constrained firms view tax savings as a source of internal financing

The insight

Traditional measures of financial constraints rely on balance sheet ratios. But managers know their constraints better than outsiders can measure. Their language reveals their perception.

We analyze how firms describe their financial situation in SEC filings. Firms that use more negative, constrained language subsequently engage in more aggressive tax planning.

Why constraints drive tax aggression

When external financing is expensive or unavailable, tax savings become a valuable source of internal funds. Constrained firms have stronger incentives to push the boundaries of tax law.

This creates a policy tension: the firms most likely to engage in aggressive tax planning are those already struggling. Cracking down on tax avoidance hits hardest on financially vulnerable companies.

Methodological contribution

This paper demonstrates that textual analysis of corporate disclosures can predict tax behavior. The language firms use contains information about their intentions that traditional financial metrics cannot capture.

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