There has been some debate as to whether managers with ambitions of empire building have incentives to invest excessively in corporate assets to grow their firms beyond optimal size and to keep unutilised resources under their control.
Managers are motivated to use corporate resources to build business empires for their own personal gains such as earning higher compensation, and satisfying their quest for status, power and prestige. Empire building managers are likely to invest funds to make acquisitions of businesses and to invest in capital expenditure projects that do not necessarily create value to their firms. Managers may engage in tax avoidance activities and use the cash savings from those activities to engage in empire building exercises. Using Sibneft, a Russian oil company, as an example, Desai, Dyck and Zingales (2007) show how corporate managers use tax avoidance schemes to transfer resources from minority shareholders to offshore entities primarily owned by the managers themselves.
In this context, an important question raised is whether corporate tax avoidance is related to managerial empire building exercises. Our research empirically investigates this question.
Our research
It has been well established that managerial rent extraction is reflected in managers’ empire building exercises. Empire building managers, through their corporate decisions, tend to opportunistically grow their companies beyond optimal size. Opportunistic decisions, such as implementing projects that involve excessive capital expenditure, aiming for asset growth beyond the optimum level required for the company’s operations, and acquisition of new businesses that increase the firm size instead of creating value to investors, are often associated with goals such as: (i) gaining power, prestige, and status; (ii) receiving excessive compensation packages; and (iii) keeping unutilised resources under managerial control.
Prior studies provide evidence that corporate managers prefer to increase the resources under their control in their desire to gain power, prestige, and status. Based on the findings of these studies, one could argue that empire building desires could lead to inefficient investment decisions. Consequently, motivated by their entrenchment objectives, managers may engage in overinvestment or underinvestment exercises.
In this context, we examine the following question: do managers use cash flows generated through tax avoidance strategies in their empire building exercises? While calling for increased attention from researchers to investigate into the agency considerations of corporate tax avoidance, our study explores the impact of corporate tax avoidance on a company’s empire building exercises.
We use a number of corporate tax avoidance proxies: (i) the five-year effective tax rate; (ii) five-year cash effective tax rate; (iii) three-year size and industry adjusted effective tax rate; and (iv) three-year size and industry adjusted cash effective tax rate. These four measures capture both tax expenses and cash paid out as taxes by a firm; they also represent firm level tax expenses as well as taxes paid by a firm relative to comparable industry peers. We measure empire building as a composite score obtained from the principal component analysis (PCA) of four proxies of empire building: (i) the acquisition ratio; (ii) level of capital expenditure; (iii) total assets growth; and (iv) growth in property, plant and equipment. These proxies are widely used in the literature for capturing the propensity of managers to be engaged in empire building.
We expect that companies with lower effective tax rates should have a tendency to engage in greater empire building exercises.
Findings
Our main hypothesis was supported in this study. Using 35,060 firm-year observations from the United States for the period 1991-2015, we find that corporate tax avoidance is positively associated with empire building, implying that firms with a higher level of tax avoidance engage in a greater level of empire building exercises. The results indicate that empire building managers are likely to invest funds generated through tax avoidance activities in acquisitions and capital expenditure projects that do not necessarily create value for their companies. Managers with empire building motives also tend to invest excessively in corporate assets to grow their companies beyond optimal size and to keep unutilised resources under their control.
Further analysis shows that the positive association between tax avoidance and empire building is more pronounced for firms with poor corporate governance and weak monitoring mechanisms in place as these inadequacies imply a high entrenchment index (E-index) score and low analyst coverage, respectively.
We also find that the association between tax avoidance and empire building is more pronounced for companies with powerful chief executive officers and for companies with weak ethical behaviour, as reflected by their corporate social responsibility performance.
Finally, we find that tax avoidance motivated by an empire building objective reduces firm value by a significant margin.
Implications
Our study shows tax avoidance strategies allow managers to reap personal benefits when a firm’s ownership is separated from its management. We contribute to the literature by providing evidence on the influence of tax avoidance on managers’ desire to engage in empire building exercises. To the best of our knowledge, the study is one of the first to link tax avoidance with empire building. We developed a composite measure of empire building using four proxies used in the literature to capture the inherently elusive corporate phenomenon of empire building and to shed light on whether corporate tax avoidance is related to this form of managerial opportunism.
Following the finding by Desai and Dharmapala (2009) that tax avoidance strategies benefit shareholders only if a strong monitoring mechanism is present, our study investigates and demonstrates that the corporate tax avoidance–empire building association is moderated by the strength of managerial disciplinary mechanisms, as implied by the E-index score and extent of analyst coverage. Our study’s findings are useful to various firm stakeholders as they provide evidence on the motives behind managers’ engagement in tax avoidance strategies.
Ultimately, attempts by firms to reduce tax payments would have a direct impact on government revenues, with subsequent consequences for various stakeholders in society. Therefore, this study’s findings are useful to regulators and other stakeholders in society.
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