Equity Risk Incentives and Corporate Tax Aggressiveness: Printed in U.S.A

DOI: 10.1111/j.1475-679X.2012.00438.
x
Journal of Accounting Research
Vol. 50 No. 3 June 2012
Printed in U.S.A.
Equity Risk Incentives and

Corporate Tax Aggressiveness
SONJA OLHOFT REGO∗ AND RYAN WILSON†
Received 13 July 2011; accepted 21 November 2011
ABSTRACT
This study examines equity risk incentives as one determinant of corporate

tax aggressiveness. Prior research finds that equity risk incentives motivate
managers to make risky investment and financing decisions, since risky activ-
ities increase stock return volatility and the value of stock option portfolios.
Aggressive tax strategies involve significant uncertainty and can impose costs
on both firms and managers. As a result, managers must be incentivized to
engage in risky tax avoidance that is expected to generate net benefits for
the firm and its shareholders. We predict that equity risk incentives motivate
managers to undertake risky tax strategies. Consistent with this prediction,
we find that larger equity risk incentives are associated with greater tax risk
and the magnitude of this effect is economically significant. Our results are
robust across four measures of tax risk, but do not vary across several proxies
for strength of corporate governance. We conclude that equity risk incentives
are a significant determinant of corporate tax aggressiveness.
∗ Indiana University; † University of Iowa. All data are available from public sources. We
thank Merle Erickson (the editor) and the anonymous referee for their helpful suggestions.
We also thank Alan Jagolinzer (our discussant at the 2009 UNC Tax Symposium), Dan Ami-
ram, Brad Blaylock, Jennifer Brown, Dan Collins, Cristi Gleason, Sanjay Gupta, Leslie Hodder,
Paul Hribar, Steve Kachelmeier, Stacie Laplante, Sean McGuire, Rick Mergenthaler, Lillian
Mills, Tom Omer, John Robinson, Terry Shevlin, Connie Weaver, and workshop participants
at Arizona State University, Indiana University, Texas A&M University, the University of Iowa,
the University of Texas, and the 2009 UNC Tax Symposium for helpful comments on earlier
versions of this paper. We also appreciate comments from the University of Washington tax
readings group.
775
Copyright
C , University of Chicago on behalf of the Accounting Research Center, 2012
776 S. O. REGO AND R. WILSON
1. Introduction
In this study, we examine equity risk incentives as one determinant of corpo-
rate tax aggressiveness. As noted by Shevlin [2007], we have an incomplete
understanding of why some firms are more tax aggressive than others. Prior
accounting research finds that corporate tax avoidance is systematically as-
sociated with certain firm attributes, including profitability, extent of for-
eign operations, intangible assets, research and development expenditures
(R&D), leverage, and financial reporting aggressiveness (e.g., Gupta and
Newberry [1997], Rego [2003], Graham and Tucker [2006], Frank, Lynch,
and Rego [2009], Wilson [2009]). Dyreng, Hanlon, and Maydew [2010]
conclude that individual managers influence their firms’ tax avoidance,
even after controlling for numerous firm characteristics. Prior research also
examines whether income tax avoidance is associated with corporate com-
pensation practices, but finds mixed evidence (e.g., Phillips [2003], Han-
lon, Mills, and Slemrod [2005], Desai and Dharmapala [2006], Armstrong,
Blouin, and Larcker [2010]). We argue that tax avoidance is a risky activity
that can impose costs on both firms and managers. As a result, managers
must be incentivized to engage in tax avoidance that involves significant
uncertainty, but is expected to generate net benefits for the firm and its
shareholders.
Equity risk incentives capture the convexity of the relation between a
manager’s wealth and stock price, and are measured as the change in value
of a manager’s stock option portfolio for a given change in stock return
volatility (e.g., Guay [1999]).1 In short, equity risk incentives reflect how
changes in stock return volatility affect managerial wealth. Prior research
provides evidence that equity risk incentives motivate managers to make
more risky—but positive net present value—investing and financing deci-
sions (e.g., Guay [1999], Rajgopal and Shevlin [2002], Coles, Daniel, and
Naveen [2006], Williams and Rao [2006]). However, these studies do not
examine the relation between equity risk incentives and risky tax planning,
which we also refer to as “risky tax avoidance” and/or “aggressive tax po-
sitions.” We argue that just as equity risk incentives motivate managers to
make more risky investing and financing decisions, they also motivate man-
agers to undertake more aggressive (i.e., risky) tax positions, and thus ac-
count for some variation in tax aggressiveness across firms.2
1 The equity risk incentives provided by convexity are different from the slope of the rela-
tion between managers’ wealth and stock price, which is typically measured as the change in a
manager’s wealth for a given change in stock price (as opposed to stock return volatility), and is
typically referred to as a manager’s “pay-for-performance sensitivity” or “delta.” See section 2
for more details.
2 We argue that equity risk incentives motivate managers to undertake more aggressive
tax positions because more aggressive tax positions are subject to greater uncertainty, which
should increase variation in after-tax profits and stock returns, and thus increase managerial
wealth by increasing the value of the manager’s stock option portfolio. See section 2 for addi-
tional discussion.
EQUITY RISK INCENTIVES AND CORPORATE TAX AGGRESSIVENESS 777
The benefits of aggressive tax positions are straightforward. They reduce

tax liabilities, which increase cash flow and can also increase after-tax net
income. However, aggressive tax positions can also impose significant costs
on firms and their managers. They require managers to invest substantial
resources in the form of fees paid to accountants and attorneys, as well
as the time that they and their employees devote to planning for and re-
solving audits with tax authorities. Costs can increase significantly if tax
authorities are successful in challenging an aggressive tax position. For
example, in 14 cases of tax sheltering, Wilson [2009] finds the interest
charges paid by firms to tax authorities amounted to 40% of the tax sav-
ings originally generated by the tax shelter transactions. Firms can also suf-
fer reputational penalties, not only in future audits with tax authorities,3
but also if aggressive tax avoidance becomes public knowledge and nega-
tively affects investors’ assessments of firm value (e.g., Hanlon and Slemrod
[2009]).
Thus, in the absence of equity risk incentives, risk-averse managers likely
prefer to undertake less risky tax planning, while risk-neutral sharehold-
ers prefer managers to implement all tax strategies that are expected to
generate net benefits for the firm, regardless of risk. Consistent with prior
research (Jensen and Meckling [1976], Smith and Stulz [1985]), we assume
that firms rely on equity-based compensation to align managerial incentives
with those of shareholders. We predict that equity risk incentives motivate
managers to undertake risky but positive net present value tax strategies.
A recent study of executive pay by the Institute for Policy Studies claims
that “corporations are rewarding CEOs for aggressive tax avoidance” (Ko-
cieniewski [2011]). However, few academic studies examine or find an as-
sociation between corporate tax avoidance and executive compensation
practices. Using compensation data obtained in a survey of corporate exec-
utives, Phillips [2003] finds that compensating division managers (but not
CEOs) on an after-tax basis leads to greater tax planning effectiveness. Han-
lon, Mills, and Slemrod [2005] find a positive association between several
equity incentive measures (i.e., bonus percentage and pay-for-performance
sensitivity) and proposed IRS deficiencies. In contrast, Desai and Dharma-
pala [2006] find that increases in the ratio of incentive compensation to
total compensation for the five highest paid executives lead to a reduction in
tax avoidance at firms with weak corporate governance. Most recently, Arm-
strong, Blouin, and Larcker [2010] find that tax director compensation is
associated with lower GAAP effective tax rates (ETRs), but they find no ev-
idence that CEO or CFO compensation is associated with any measure of
corporate tax avoidance. We contribute to this stream of research by con-
sidering a previously overlooked determinant of corporate tax avoidance:
equity risk incentives.
3 For example, assume firm X was caught avoiding millions of dollars of federal income
taxes in 2006. As a consequence, the next cycle of federal, state, and foreign tax audits may
subject the firm to greater scrutiny over a longer time period, because this company has gained
the reputation of being a substantial tax avoider.
If equity risk incentives generally mitigate the risk-related incentive prob-

lem by motivating managers to implement tax strategies that are expected
to generate net benefits (i.e., benefits adjusted for risk), then we expect
a positive association between equity risk incentives and measures of risky
tax avoidance for a broad sample of firms. Because equity risk incentives
and risk-taking behaviors are likely endogenously related (e.g., Rajgopal
and Shevlin [2002], Hanlon, Rajgopal, and Shevlin [2003], Coles, Daniel,
and Naveen [2006]), we use a system of equations to model the relation
between equity risk incentives and managerial tax choices.4
Consistent with Hanlon and Heitzman [2010], we view tax avoidance
as encompassing a spectrum of tax planning activities with outcomes that
range from certain to uncertain, where uncertain (i.e., aggressive or risky)
tax positions are those that are supported by a relatively weak set of facts
and are, thus, less likely to be sustained upon audit. Given our predic-
tion that equity risk incentives cause managers to undertake more risky
tax positions, our construct of interest is tax aggressiveness, which involves
greater uncertainty. However, existing measures of tax avoidance reflect ag-
gressive tax positions with error. Thus, we use several measures of tax risk
in our empirical tests. We utilize three existing measures of tax avoidance,
including discretionary book-tax differences, tax shelter prediction scores,
and cash ETRs.5 We also estimate the amount of unrecognized tax bene-
fits (UTBs) that sample firms have accrued under Interpretation No. 48
(FIN 48). UTBs represent the amount of income taxes associated with un-
certain tax positions and thus are one proxy for risky tax planning. We esti-
mate the amount of UTBs for our broad sample of firms for which we have
CEO and CFO compensation data, based on the UTB prediction model
from Cazier et al. [2009] and hand-collected UTB data for S&P 500 and
S&P 400 firms. To the extent that we obtain similar results based on these
four measures of tax risk, we can be confident regarding the robustness of
our results.
Our empirical results are consistent with expectations. We first demon-
strate in correlation analyses that our measures of tax risk are positively
associated with both stock return volatility and CEO and CFO equity risk
incentives, consistent with higher equity risk incentives motivating man-
agers to undertake risky tax strategies that increase stock return volatility. In
multivariate analyses, CEO and CFO equity risk incentives continue to be
4 Similar to Rajgopal and Shevlin [2002] and Coles, Daniel, and Naveen [2006], we use
two-stage least squares to estimate our simultaneous system of equations, where proxies for
corporate tax avoidance and equity risk incentives are the endogenous, dependent variables.
See section 3 for more details.
5 Cash ETRs reflect a broad spectrum of tax avoidance activities with outcomes that range
from certain to uncertain, and thus they are the measure that is farthest from the underlying
construct of tax aggressiveness. Nonetheless, we use cash ETRs as a proxy for tax aggressiveness
because they have several advantages over the other proxies for tax risk, as explained in greater
detail in section 3.1.
positively associated with our measures of tax risk despite the inclusion of
numerous control variables, including measures of firm performance, pay-
for-performance sensitivity, size, operating volatility, R&D expenditures,
leverage, and foreign operations. We also find that larger firms with greater
investment opportunities and higher CEO and CFO cash compensation
rely on more equity risk incentives than other firms.
Our results for CEOs are highly robust to a variety of supplemental
analyses, including the use of alternative estimation methods and allowing
corporate governance strength to moderate the relation between equity
risk incentives and risky tax avoidance. Interestingly, we find some evidence
that the positive relation between equity risk incentives and risky tax avoid-
ance for CFOs is less robust than the same relation for CEOs, consistent with
CEO equity risk incentives having greater influence over corporate tax risk
taking.
Prior research does not investigate this link between equity risk in-
centives and risky tax avoidance. The high rate of tax-related, internal
control deficiencies following the implementation of Section 404 of the
Sarbanes–Oxley Act of 2002 (Gleason, Pincus, and Rego [2011]), com-
bined with the IRS’s pursuit of abusive tax shelter transactions and its im-
plementation of Schedule UTP in 2010, have significantly increased the
focus on tax risk in corporate America.6 This increased focus on tax risk
has caused researchers to more closely examine why some firms are more
tax aggressive than others. Uncertain (i.e., risky) tax positions require man-
agerial effort and can impose costs on both firms and managers. Thus, risk-
averse managers must be properly incentivized to undertake risky tax strate-
gies that generate net benefits for the firm and its shareholders. Our results
suggest that equity risk incentives provide managers such incentives. Our
study extends prior research that investigates whether incentive compensa-
tion motivates managers to undertake risky investments (e.g., Guay [1999],
Rajgopal and Shevlin [2002], Coles, Daniel, and Naveen [2006], Williams
and Rao [2006]), and it increases our understanding of whether and how
corporate tax avoidance, equity risk incentives, and corporate governance
interact.
The paper proceeds as follows: section 2 discusses prior research and de-
velops hypotheses. Section 3 explains the research design, while section 4
discusses the sample selection process and empirical results. Section 5
presents supplemental analyses, and section 6 concludes.
6 Starting with tax year 2010, the IRS requires firms to disclose on Schedule UTP detailed
information regarding each uncertain tax position for which the taxpayer has recorded a
reserve in its financial statements. In part I, taxpayers need to disclose the primary Internal
Revenue Code sections to which each tax position relates, whether the tax position generates
temporary or permanent book-tax differences, whether each position is considered a “major
tax position” (i.e., greater than or equal to 10% of the size of all tax positions listed in parts
I and II), and the rank of each position based on its size relative to the size of all other tax
positions listed in parts I and II. In part III, taxpayers also need to provide concise descriptions
of each tax position listed in parts I and II.
2. Background and Hypothesis Development

2.1 DETERMINANTS OF TAX AVOIDANCE
Prior accounting research identifies numerous firm characteristics as
sources of variation in ETRs and other measures of tax avoidance across
firms. Several studies investigate the relation between ETRs and firm size
and find conflicting results, depending on how ETRs are measured, the
time period analyzed, and the model specification (e.g., Stickney and
McGee [1982], Zimmerman [1983], Porcano [1986], Shevlin and Porter
[1992], Rego [2003]). Gupta and Newberry [1997] provide evidence that
lower ETRs are associated with lower profitability, but higher leverage and
capital intensity. Rego [2003] demonstrates that multinational corporations
with more extensive foreign operations have lower worldwide and foreign
ETRs. Recent studies also show that firms accused of using tax shelters are
more profitable and have larger book-tax differences, greater foreign oper-
ations, subsidiaries in tax havens, more research and development expen-
ditures, and less leverage (e.g., Graham and Tucker [2006], Wilson [2009],
Lisowsky [2010]).
Recent accounting research also investigates the links between differ-
ent ownership structures and corporate tax avoidance. Chen et al. [2010]
provide evidence that family-owned firms avoid less income tax than non-
family-owned firms. They argue that the dominant owner managers of
family-owned firms are willing to forgo the benefits of tax planning to avoid
concerns by minority shareholders that tax avoidance masks rent extrac-
tion by the family owner managers. McGuire, Wang, and Wilson [2011]
find that firms with dual class stock ownership engage in less tax avoid-
ance than other firms, consistent with managers that are insulated from
takeovers avoiding the costly effort associated with increased tax avoidance.
Lastly, Badertscher, Katz, and Rego [2011] provide evidence that private eq-
uity firms significantly increase the tax planning effectiveness of the firms in
which they invest. This tax planning expertise persists even after private eq-
uity firm ownership is substantially reduced or terminated. Thus, different
ownership structures have a significant impact on corporate tax practices.
Despite all of these prior research findings, we still have an incom-
plete understanding as to which factors drive variation in tax avoidance
across firms. One possible determinant of corporate tax avoidance that has
not been fully explored involves managers and corporate compensation
practices.
2.2 LINKING CORPORATE COMPENSATION PRACTICES TO TAX AVOIDANCE

Relatively few studies have examined the relation between executive com-
pensation practices and corporate tax avoidance.7 Crocker and Slemrod
7 Although they do not examine the link between executive compensation and tax avoid-
ance, Dyreng, Hanlon, and Maydew [2010] provide evidence that individual CEOs and CFOs
[2005] develop a theoretical model of the contractual relationship be-

tween shareholders of the firm and the tax director, and examine how
compensation contracts affect tax avoidance. They describe how the board
of directors, acting on behalf of shareholders, structures the tax director’s
compensation contract to align his/her incentives with those of the share-
holders. It is in the shareholders’ interest for the tax director to reduce the
firm’s tax liabilities, net of any costs of doing so. Crocker and Slemrod state
that, to properly align incentives, “it may be appropriate for the tax officer’s
salary to depend (inversely) on the effective tax rate achieved” (p. 1595).
Phillips [2003] empirically investigates this theoretical link between com-
pensation and tax avoidance. In particular, he examines whether compen-
sating managers based on after-tax performance measures leads to lower
ETRs. Based on a sample of 209 surveyed corporate executives, Phillips
finds that compensating business unit managers, but not CEOs, on an after-
tax basis directly leads to lower ETRs. However, Phillips also notes that after-
tax CEO performance measures may have an indirect effect on ETRs, since
CEOs that are compensated on an after-tax basis are more likely to compen-
sate their business unit managers on an after-tax basis. Gaertner [2011] re-
visits the findings in Phillips [2003] by estimating the sensitivity of CEO cash
compensation to total tax expense, and finds that firms whose CEOs exhibit
higher compensation-to-tax sensitivities report lower GAAP and cash ETRs,
consistent with CEO compensation policy having a significant impact on
corporate tax avoidance.
Desai and Dharmapala [2006] examine how stock-based compensation
influences tax sheltering decisions. They rely on two competing theories
of how incentive compensation should affect tax sheltering. The first the-
ory predicts a positive relation between incentive compensation and tax
sheltering because incentive compensation should align managerial in-
centives with those of shareholders, inducing managers to engage in tax
avoidance that increases firm value. The second theory contends that tax
sheltering facilitates managerial rent extraction. In this case, corporate gov-
ernance strength should moderate the relation between incentive compen-
sation and tax sheltering, since weak corporate governance should allow
greater managerial rent extraction through tax sheltering. Taken together,
these two theories generate an ambiguous prediction for the net impact of
incentive compensation on tax sheltering (i.e., increasing incentive com-
pensation should increase tax sheltering that increases firm value, but de-
crease tax sheltering associated with managerial rent extraction). Desai and
Dharmapala test their model across well-governed and weaker-governed
firms and find that increases in incentive compensation for the five highest
paid executives reduce the level of tax sheltering, and this negative effect
influence corporate tax avoidance—as measured by GAAP and cash ETRs—even after con-
trolling for numerous firm characteristics.
is driven by weaker-governed firms.8 They conclude that incentive compen-

sation aligns managers’ incentives with those of shareholders and reduces
opportunistic tax sheltering.
Desai and Dharmapala’s [2006] results are contrary to those in Han-
lon, Mills, and Slemrod [2005], which finds that pay-for-performance
sensitivities for the five highest paid executives are positively associated with
proposed IRS audit deficiencies. However, the results of these two studies
are not directly comparable, as they use different data sets (Compustat vs.
IRS data), different measures of tax avoidance (discretionary book-tax dif-
ferences vs. proposed IRS audit deficiencies), and different compensation
variables (the ratio of the value of stock option grants to total compensation
vs. pay-for-performance sensitivities), among other differences.
Armstrong, Blouin, and Larcker [2010] examine whether the level of
total compensation and “compensation mix”9 for top executives are associ-
ated with several measures of tax avoidance. Their results indicate that the
tax director’s total compensation and compensation mix have incremental
explanatory power with respect to GAAP ETRs, but not with other mea-
sures of tax avoidance (including cash ETR). Armstrong et al. also find that
their compensation measures for CEOs and CFOs are not associated with
any measure of tax avoidance. Armstrong et al. interpret their results as
consistent with tax directors (but not CEOs or CFOs) being compensated
to generate a favorable impact on financial statements through reported
tax expense (but not through cash tax savings). Taken together, prior re-
search provides mixed results regarding the link (if any) between executive
compensation and corporate tax avoidance.
2.3 HYPOTHESIS DEVELOPMENT
We propose that one potential missing link between executive compen-
sation and corporate tax avoidance is equity risk incentives. Prior research
describes how stock options provide managers with incentives that mitigate
the risk-related incentive problem between managers and shareholders
(e.g., Jensen and Meckling [1976], Smith and Stulz [1985], Guay [1999]).
In particular, stock options motivate managers to undertake risky but posi-
tive net present value projects because the value of an option increases with
both stock price (which we refer to as the slope effect)10 and stock return
volatility (which we refer to as the risk incentive effect).11 While the slope
8 The primary measure of incentive compensation in Desai and Dharmapala [2006] is the
value of stock option grants as a fraction of total compensation for the five highest paid exec-
utives.
9 Compensation mix is the ratio of variable compensation to total compensation, where
variable compensation includes bonus, restricted stock, and stock options.

10 The term “slope effect” refers to the slope of the relation between a manager’s wealth and
stock price. The slope effect is also referred to as a manager’s pay-for-performance sensitivity
and/or “delta.”
11 The term “risk incentive effect” refers to the convexity (or curvature) of the relation
between a manager’s wealth and stock price, and is also referred to as the sensitivity of a
manager’s wealth to stock return volatility and/or “vega.”
effect motivates managers to undertake positive net present value projects,

the risk incentive effect motivates managers to increase stock return volatil-
ity by undertaking risky projects. Holding the slope effect constant, man-
agers with larger equity risk incentives have greater incentive to undertake
actions that increase firm risk, because option values increase with stock
return volatility.
Prior studies find that larger equity risk incentives are associated with
greater managerial risk taking, particularly with respect to investing and
financing decisions (e.g., Guay [1999]). Rajgopal and Shevlin [2002] find
evidence consistent with greater equity risk incentives leading to higher
future exploration risk taking in the oil and gas industry. Coles, Daniel, and
Naveen [2006] show that higher equity risk incentives are associated with
riskier corporate policy choices, including greater investment in research
and development, lower capital expenditures, higher leverage, and more
concentrated market and industry focus. Cohen, Dey, and Lys [2009] find
evidence that higher risk incentives are associated with greater managerial
risk taking; however, they conclude that the magnitude of that association
has declined since the Sarbanes–Oxley Act of 2002.
Our study examines the impact of equity risk incentives on managers’
choices with respect to risky tax strategies. Consistent with prior research,
we assume that firms utilize equity-based compensation to align managerial
incentives with those of shareholders (e.g., Jensen and Meckling [1976],
Smith and Stulz [1985]). Building on Guay’s [1999] theory of equity risk
incentives, we predict that greater equity risk incentives motivate managers
to undertake more risky tax strategies that increase stock return volatility.
More risky tax avoidance strategies should increase stock return volatility,
since more risky tax planning increases the uncertainty surrounding fu-
ture tax outcomes.12 This greater uncertainty should increase the disper-
sion in investor expectations, which should not only increase the firm’s
stock return volatility but also translate into higher stock option valua-
tions and, thus, greater managerial wealth. Our formal hypothesis predicts
that greater equity risk incentives motivate managers to adopt risky tax
strategies:
H1: Larger CEO and CFO equity risk incentives are positively associated
with more risky tax avoidance.
Our study focuses on CEO and CFO compensation. Since neither the
CEO nor the CFO has direct responsibility over the tax function, one may
12 For example, assume that taxable income prior to any tax planning is $100, which would
generate a corporate tax liability of $35 and after-tax income of $65. The firm can then decide
to engage in either more or less risky tax planning to reduce its tax liability. If the firm engages
in less aggressive tax planning, the tax deduction is $10, resulting in taxable income of $90, a
corporate tax liability of $31.50, and after-tax income of $58.50. In contrast, if the firm engages
in more aggressive tax planning, the tax deduction is $20, resulting in taxable income of $80, a
corporate tax liability of $28, and after-tax income of $52. The less aggressive tax planning has
a range of possible after-tax income ranging from $58.50 to $65, while the more aggressive tax
planning has a range of possible after-tax income ranging from $52 to $65.
ask why we do not focus on the compensation of tax directors rather than
the compensation of higher-level executives. We focus on CEOs and CFOs
due to evidence that corporate tax departments were increasingly viewed as
profit centers during the 1990s and early 2000s (e.g., Crocker and Slemrod
[2005], Robinson, Sikes, and Weaver [2010]).13 We argue that the desire
for tax departments to behave as profit centers likely came from top exec-
utives, who have been under increasing pressure to meet earnings targets
and maintain equity valuations (Jensen [2005]). Moreover, our view of top
executives pressuring tax departments to increase after-tax earnings is con-
sistent with results in Dyreng, Hanlon, and Maydew [2010], which suggest
that CEOs and CFOs influence the level of a firm’s tax avoidance activity.
3. Research Design
3.1 PROXIES FOR RISKY TAX AVOIDANCE
We utilize several measures of tax avoidance because no single measure
perfectly captures the underlying construct (i.e., risky tax planning). We
use three existing tax avoidance measures, including discretionary per-
manent differences (DTAX ), a tax shelter prediction score (SHELTER),
and the five-year cash ETR (CASH ETR). Prior research demonstrates
that DTAX and SHELTER are significantly associated with actual cases of
tax sheltering (Frank, Lynch, and Rego [2009], Wilson [2009]) and thus
should also reflect risky tax positions. In contrast, Hanlon and Heitzman
[2010] note that CASH ETR reflects all transactions that have any effect
on the firm’s explicit tax liability, including tax positions with both certain
and uncertain outcomes, and thus is the measure that diverges the farthest
from the underlying construct of aggressive tax avoidance. Nonetheless,
it has several advantages over the other tax measures, including the fact
that it reflects tax avoidance that generates temporary book-tax differences
(DTAX does not) and it is not estimated based on a set of broad firm char-
acteristics (SHELTER is). Moreover, it is widely used in the tax literature
and thus should provide insights into the consistency of our results across
several measures of tax risk. See appendix A for details on how we calculate
each of these measures of tax avoidance.
We also utilize a fourth measure that proxies for uncertain tax positions
as disclosed by the firm. Specifically, we estimate the amount of UTBs that
sample firms have accrued under Interpretation No. 48 (FIN 48). UTBs
represent the amount of income taxes associated with uncertain tax posi-
tions and thus are one proxy for risky tax planning. We use hand-collected
13 Moreover, it seems relatively straightforward that tax directors’ compensation should be
based on effective tax planning, since these individuals have direct oversight of the tax func-
tion. The question remains, however, as to who decided to link the tax director’s compensation
to measures of effective tax planning (e.g., the firm’s ETR). If the CEO and/or CFO view the
tax department as a profit center and then evaluate the tax director based on tax-based per-
formance metrics, the pressure for aggressive tax planning has “come from the top.”
UTB data and the following prediction model from Cazier et al. [2009] to
estimate the amount of UTBs for our sample of firms for which we have
CEO and CFO compensation data:
UTB it = α0 + α1 PT ROAt + α2 SIZE t + α3 FOR SALEt + α4 R&D t
+ α5 LEV t + α6 DISC ACCRt + α7 SG&At + α8 MTB t
+ α9 SALES GRt + εit (1)
We use the estimated coefficients from equation (1), which are based on
data for firms in the S&P 500 and S&P 400 for fiscal years 2007–2009, to
calculate predicted UTBs (PRED UTB) for the sample of firms used in this
study. While this measure of tax risk is theoretically most similar to the un-
derlying construct of interest (i.e., risky tax positions), it also contains mea-
surement error. First, UTBs contain measurement error as a proxy for the
riskiness of firms’ tax positions because the magnitude of UTBs is a function
of both the uncertainty underlying firms’ tax positions and the level of con-
servatism exhibited by managers in their financial reporting choices (e.g.,
Hanlon and Heitzman [2010]). Second, our measure of predicted UTBs
also contains measurement error because we must use an out-of-sample
estimation procedure for our sample of firms for which we have CEO
and CFO compensation data. To the extent that we obtain similar results
across our four measures of tax risk (i.e., DTAX , SHELTER, CASH ETR, and
PRED UTB), we can be confident that our results are highly robust.
3.2 MODELING RISKY TAX AVOIDANCE AND EQUITY RISK INCENTIVES
H1 predicts that larger CEO and CFO equity risk incentives are associ-
ated with more risky tax avoidance. Similar to other studies that examine
the relation between equity risk incentives and managerial risk taking (e.g.,
Rajgopal and Shevlin [2002], Coles, Daniel, and Naveen [2006]), we ar-
gue that equity risk incentives and risky tax avoidance are likely endoge-
nously related. In particular, not only should equity risk incentives motivate
managers to undertake risky tax strategies, but current tax strategies may
also be associated with the equity risk incentives imposed on managers.
In untabulated analyses, most results for the Hausman test indicate that
our four measures of tax risk and equity risk incentives are endogenously
related. In particular, the results indicate that tax risk is not endogenous
in the equity risk incentives regression [equation (3), below] when either
PRED UTB or SHELTER is the tax risk proxy, but it is endogenous when
DTAX or CASH ETR are the proxies. In contrast, equity risk incentives are
endogenous in the tax risk regressions [equation (2) below] based on all
four tax risk proxies.
Thus, we test H1 by adapting the models of equity risk incentives and
managerial risk taking in Rajgopal and Shevlin [2002] and Coles, Daniel,
and Naveen [2006]. We implement the following simultaneous system of
equations where risky tax avoidance (TAX RISK ) and equity risk incentives
(RISK INCENT ) are the endogenous dependent variables. We estimate the
parameters for our system of equations using two-stage least squares (where
firm and time subscripts are omitted for convenience):
TAX RISK = α1 RISK INCENT + α2 SLOPE + α3 PT ROA + α4 NOL
+ α5 Log(ASSETS) + α6 MNC + α7 LEV + α8 R&D + α9 CAPX
+ α10 DISCR ACCR + α11 σ (ROA) + α12 YEAR + α13 INDUS + ε
(2)
RISK INCENT = β1 TAX RISK + β2 CASH COMP + β3 AGE + β4 BTM

+ β5 Log(ASSETS) + β6 INVESTMENT + β7 σ (RET )
+ β8 SLOPE + α9 YEAR + α10 INDUS + φ (3)
As previously discussed, our four proxies for risky tax avoidance

(TAX RISK ) are DTAX , SHELTER, CASH ETR, and PRED UTB. A positive
(negative) coefficient on RISK INCENT (α 1 ) in the DTAX, SHELTER, and
PRED UTB (CASH ETR) regressions would support our hypothesis that
greater equity risk incentives motivate managers to engage in more risky
tax avoidance that increases stock return volatility and also stock option
portfolio and firm values.
Equation (2) models risky tax avoidance (TAX RISK ) as a function
of equity risk incentives (RISK INCENT ), pay-for-performance sensitivity
(SLOPE), pretax return on assets (PT ROA), an indicator variable for
net operating loss carryfowards (NOL), the natural log of total assets
(Log(ASSETS)), a proxy for foreign operations (MNC), leverage (LEV ),
R&D and capital expenditures (CAPX ), discretionary accruals (DISC
ACCR), and the standard deviation of pretax return on assets (σ (ROA)).
Because SHELTER and PRED UTB are calculated based on a variety of firm
characteristics, including firm size, profitability, foreign operations, lever-
age, and R&D expenditures, those variables are excluded from equation
(2) regressions where SHELTER and PRED UTB are the dependent vari-
ables (see results in table 4).
Two-stage least squares estimation requires that each equation in the sys-
tem have at least one unique exogenous variable that is not related to the
other endogenous variables. In our research setting, it is difficult to identify
firm characteristics that are significantly associated with tax risk but not eq-
uity risk incentives, and vice versa. Nonetheless, we select PT ROA and NOL
as the exogenous variables for equation (2) and AGE and book-to-market
ratio (BTM ) as the exogenous variables for equation (3), since a priori we
expect these variables to exhibit little if any correlation with the “other”
endogenous variable in our system of equations. For example, we do not
expect PT ROA to be highly correlated with equity risk incentives, and we
do not expect AGE to be highly correlated with tax risk. Untabulated corre-
lation analyses reveal that PT ROA and NOL are highly correlated with all
four TAX RISK measures, while AGE and BTM are highly correlated with
equity risk incentives. The same analyses also indicate that these exogenous
variables generally exhibit little or no correlation with the “other” endoge-
nous variable.14
Two-stage least squares estimation calculates the “instrument” (i.e., pre-
dicted value) for each endogenous variable by regressing each endogenous
variable on all of the exogenous variables in the first-stage regression. We
evaluated the quality of our TAX RISK and RISK INCENT instruments by
examining the explanatory power of the first-stage regressions through F -
tests (results untabulated). Staiger and Stock [1997] claim that a first-stage
F -statistic of less than 10 is suggestive of weak instruments. Our results
indicate F -statistics above 10 for each first-stage regression (and for each
TAX RISK proxy). Taken together, the combination of correlation analyses
and F -tests suggest that we have identified a reasonable set of exogenous
variables and instruments for our system of equations.15
Results in Guay [1999] and Coles, Daniel, and Naveen [2006] show that
equity risk incentives and pay-for-performance sensitivity are positively re-
lated. Thus, we include SLOPE in equation (2) to control for any associa-
tion between tax risk and pay-for-performance sensitivity that RISK INCENT
might otherwise capture. We include PT ROA, NOL, Log(ASSETS), MNC,
LEV , R&D, CAP EXP , and DISCR ACCR in equation (2) because prior re-
search finds significant associations between tax avoidance and these firm
characteristics (e.g., Gupta and Newberry [1997], Rego [2003], Graham
and Tucker [2006], Frank, Lynch, and Rego [2009], Wilson [2009]). Be-
cause greater variation in pretax profitability should impact a firm’s tax
planning strategies, we control for σ (ROA). Lastly, we include year (YEAR)
and industry (INDUS) fixed effects in both equations (2) and (3). (See ap-
pendix A for complete variable definitions.)
We calculate RISK INCENT consistent with Guay [1999], who finds that
“stock options, but not common stockholdings, play an economically sig-
nificant role in increasing the convexity of the relation between managers’
14 Specifically, we examined the correlations between each exogenous variable and the
“other” endogenous variable in our system of equations. In some cases, the exogenous vari-
ables exhibit small but significant correlations with the “other” endogenous variable. To deter-
mine whether these small but significant correlations have a significant impact on our main
results, we eliminated any exogenous variable that was correlated with the “other” endogenous
variable at the 0.10 level or higher. These eliminations do not alter inferences from the results
shown in tables 4 and 5. In particular, the coefficients on CEO RISK INCENT were significant
in the predicted direction in all four TAX RISK regressions (similar to table 4), and the co-
efficients on CFO RISK INCENT were significant in the predicted direction in three of four
TAX RISK regressions (similar to table 5).
15 In supplemental analyses, we adopt an alternative approach and use ordinary least
squares to estimate equation (2); however, RISK INCENT is lagged by one year to avoid si-
multaneity bias. In addition, we include firm and year fixed effects to control for correlated
omitted variables. This alternative approach is also followed by Coles, Daniel, and Naveen
[2006] in their tables 2, 4, and 6. The results from this alternative estimation method are qual-
itatively similar to those for our system of equations (2) and (3). See section 5.1 for a detailed
discussion.
wealth and stock price” (p. 45). Thus, we calculate RISK INCENT as the
change in the manager’s stock option portfolio value (but not common
stockholdings) for a given change in stock return volatility. Shareholders
must manage equity risk incentives (i.e., the convexity of the relation be-
tween managers’ wealth and stock price) to motivate managers to under-
take risky (but positive net present value (NPV)) projects.
Equation (3) is based on models of equity risk incentives in Rajgopal and
Shevlin [2002], Coles, Daniel, and Naveen [2006], and Cohen, Dey, and
Lys [2009]. We include TAX RISK in equation (3) due to the endogenous
relation between managerial risk taking—in this case, risky tax avoidance—
and equity risk incentives. Although the discussion leading up to H1 focuses
on whether equity risk incentives motivate managers to engage in risky tax
planning (i.e., H1 focuses on RISK INCENT in equation (2)), it is also pos-
sible that tax avoidance influences the equity risk incentives that share-
holders impose on managers. A positive (negative) coefficient on DTAX,
SHELTER, and PRED UTB (CASH ETR) in equation (3) would support this
possibility.
Equation (3) also includes Log(ASSETS), the BTM , total current pe-
riod investment in R&D, net capital expenditures, and corporate acqui-
sitions (INVESTMENT ), stock return volatility (σ (RET)), managerial risk
aversion as proxied by the manager’s age (AGE) and cash compensation
(CASH COMP ), and the sensitivity of the manager’s wealth for a given
change in stock price (SLOPE). Consistent with results in Rajgopal and
Shevlin [2002], Coles, Daniel, and Naveen [2006], and Cohen, Dey, and Lys
[2009], we expect that larger firms (Log(ASSETS)), with greater growth op-
portunities (BTM ) and higher current period investment (INVESTMENT ),
utilize greater equity risk incentives. We also expect a positive relation be-
tween equity risk incentives and stock return volatility (σ (RET)), based on
findings in Guay [1999] and Coles, Daniel, and Naveen [2006]. In contrast,
we make no predictions regarding the coefficients on our proxies for man-
agerial risk aversion (CASH COMP and AGE), since older managers with
greater cash compensation may have more diversified portfolios and thus
be less risk averse and require fewer equity risk incentives. Alternatively,
these managers could require greater equity risk incentives to more closely
align their interests with those of shareholders, since these managers are
likely closer to retirement.
Lastly, we expect firms whose managers’ wealth is more sensitive to stock
price changes to also have greater equity risk incentives (e.g., Guay [1999],
Rajgopal and Shevlin [2002]). Because stock options affect both the slope
and the convexity of the relation between managers’ wealth and stock price,
we need to hold the slope effect constant in our model of equity risk incen-
tives. Thus, equation (3) includes SLOPE, which we calculate as the change
in the total value of stock and options held by the manager for a 1% change
in stock price, consistent with Core and Guay [1999].
TABLE 1
Results for Unrecognized Tax Benefit (UTB) Prediction Model
UTB
Predicted Sign Coeff t-Stat
Intercept ? −0.004 −1.62
PT ROA + 0.011 3.48∗∗∗
SIZE + 0.001 3.49∗∗∗
FOR SALE + 0.010 8.53∗∗∗
R&D + 0.092 12.97∗∗∗
DISC ACCR + −0.002 −0.33
LEV − 0.003 1.82∗
MTB ? 0.000 2.87∗∗∗
SG&A ? 0.014 7.33∗∗∗
SALES GR ? −0.018 −6.38∗∗∗
Observations 2,162
Adjusted R 2 21.82%
All variables are calculated as described in appendix A.
∗ ∗∗
, , and ∗∗∗ denote two-tailed (one-tailed when there is a predicted sign) statistical significance at 10%,
5%, and 1%, respectively.
4. Data and Discussion of Empirical Results

4.1 SAMPLE SELECTION PROCESS
We acquire data from several sources to perform our empirical tests
of H1. We obtain CEO and CFO compensation data from Compustat’s
Execucomp Annual Compensation database, financial statement data from
Compustat’s Fundementals Annual database, and stock return data from
CRSP. We hand collect UTB data for S&P 500 and S&P 400 firms from their
Form 10-K filings for fiscal years 2007–2009. For our corporate governance
tests, we obtain board of director data from RiskMetrics and entrenchment
index data from Lucian Bebchuk’s Web site. For a firm-year observation to
be included in our sample, it must have all data necessary to calculate the
variables included in equations (2) and (3). We also require firms to have
cumulative, positive pretax income over the four years ending in year t. We
eliminate firms with cumulative, negative pretax income because we expect
the association between equity risk incentives and risky tax avoidance to be
attenuated for firms that are not profitable. As a result, we focus our analy-
sis on firms where tax planning is likely to be a priority. The sample for our
first set of tests consists of 18,240 CEO-year observations from 1992 through
2009 that were successfully matched to CRSP and Compustat firm-year data.
We winsorize all variables at the 1st and 99th percentiles.
We first estimate equation (1) based on our hand-collected UTB data
for S&P 500 and S&P 400 firms. Table 1 contains the results for this ordi-
nary least squares regression. The explanatory power of our model is fairly
high, as evidenced by the adjusted R-squared of 21.82% and the F -statistic
of 107.78 (p-value < 0.01). The results in table 1 indicate that larger (SIZE)
firms, with greater profitability (PT ROA), foreign sales (FOR SALE),
leverage (LEV ), research and development expenditures (R&D), selling

and selling, general, and administrative (SG&A) expenditures, and higher
market-to-book ratios (MTB) report larger UTBs. In contrast, firms with
higher sales growth report lower UTBs. These results are largely consistent
with those in Cazier et al. [2009], on which we base our model of UTBs.16
Equation (1) does not include firm, year, or industry fixed effects to
simplify the estimation of UTBs for our broad sample of firms for which
we have CEO and CFO data. In particular, we use the coefficient estimates
from table 1 to calculate predicted UTBs (PRED UTB) for each firm-year
observation in our CEO and CFO subsamples.
Table 2 provides descriptive statistics for PRED UTB and all other vari-
ables included in equations (2) and (3). With respect to the TAX RISK vari-
ables, we calculate DTAX using all Compustat firm-years from 1992 through
2009 that have the requisite data and then match these firm-years to the
CEO and CFO sample observations. As a result, the mean of DTAX (0.03)
is not zero despite being the residual from annual cross-sectional regres-
sions. Mean (median) CASH ETR is 0.27 (0.28) and both the mean and
median values of PRED UTB are 0.01, or 1% of lagged total assets. Given
mean (median) lagged total assets of $9,544 million ($1,499 million) for
the CEO sample (results untabulated), the mean (median) PRED UTB is
approximately $111 million ($15 million) for CEO sample observations. By
definition, the mean of SHELTER is 20%, since SHELTER is an indicator
variable set equal to 1 for firm-years in the top quintile of tax shelter pre-
diction scores, as computed in Wilson [2009].
Among the tax model variables, table 2 shows that both the mean and
median values of CEO equity risk incentives (CEO RISK INCENT ) are sub-
stantially larger than those for CFOs (CFO RISK INCENT ), consistent with
CEOs having greater incentives than CFOs to undertake risky (but positive
NPV) projects that increase stock return volatility.17 Table 2 also indicates
that sample firms are largely profitable with mean (median) PT ROA of
0.10 (0.08), have relatively low mean and median standard deviations in an-
nual earnings over the four prior years (σ (ROA)), and relatively low mean
and median capital (CAPX ) and R&D expenditures in the current year.
Based on the method developed by Oler, Shevlin, and Wilson [2007], we
estimate the percentage of total assets that are located outside the United
States and find the mean (median) percentage of foreign assets (MNC) to
16 Although our sample period of 2007–2009 is different from the sample period in Cazier
et al. [2009], the results are substantially similar across our table 1 and Cazier et al.’s table 5.
The two qualitative differences are: (1) the coefficient on DISC ACCR is not significant in our
table 1, but it is negative and significant in Cazier et al.’s table 5, and (2) the coefficient on
MTB is positive and significant in our table 1, but not significant in Cazier et al.’s table 5. In
addition, because we do not include firm, year, or industry fixed effect in equation (1), the
adjusted R-squared in our table 1 is lower than those in Cazier et al.’s table 5.
17 However, we note that we do not have as many CFO observations (N = 11,040) as CEO
observations (N = 18,240) and, therefore, these descriptive statistics do not represent the
same set of firm-year observations.
TABLE 2
Descriptive Statistics for Tax Risk, Equity Risk Incentives, and Other Regression Variables
Percentiles
N = 18,240 (CFO N = 11,040) Mean Std. Dev. 25th 50th 75th
TAX RISK Variables:
DTAX 0.03 0.09 0.00 0.01 0.05
SHELTER 0.20 0.40 0.00 0.00 0.00
PRED UTB 0.01 0.01 0.01 0.01 0.02
CASH ETR 0.27 0.13 0.19 0.28 0.34
TAX RISK Model Variables:
CEO RISK INCENT ($000s) 132.10 230.47 14.76 47.88 139.24
CFO RISK INCENT ($000s) 28.71 49.69 2.73 10.82 30.65
PT ROA 0.10 0.08 0.04 0.08 0.14
NOL 0.28 0.45 0.00 0.00 1.00
Log(ASSETS) 7.48 1.58 6.31 7.31 8.47
MNC 0.15 0.24 0.00 0.00 0.28
LEV 0.21 0.16 0.06 0.21 0.33
R&D 0.02 0.04 0.00 0.00 0.03
CAPX 0.06 0.05 0.02 0.04 0.08
DISC ACCR −0.03 0.08 −0.06 −0.02 0.02
σ (ROA) 0.03 0.03 0.01 0.02 0.04
RISK INCENT Model Variables:
BTMt 0.50 0.32 0.28 0.43 0.63
INVESTMENTt 0.11 0.10 0.05 0.09 0.15
CEO CASHCOMP ($000s) 1,252.28 1,126.57 593.34 919.77 1,476.78
CFO CASHCOMP ($000s) 322.75 154.08 214.96 295.54 400.00
CEO AGE 63.36 9.26 57.00 63.00 69.00
CFO AGE 54.31 7.32 51.00 52.00 58.00
σ (RET) 0.40 0.18 0.27 0.36 0.49
CEO SLOPE ($000s) 821.51 2,002.34 82.86 227.54 637.97
CFO SLOPE ($000s) 70.95 116.04 8.91 29.52 77.90
See appendix A for variable definitions.
be 15% (0%).18 We also note that 28% of CEO sample firms report the ex-
istence of net operating loss carryforwards (NOL) at the beginning of the
year.
Among the equity risk incentive model variables, table 2 shows that sam-
ple firms have mean (median) BTM of 50% (43%). The mean and me-
dian values for INVESTMENT , which reflects acquisitions and capital and
R&D expenditures, are 11% and 9% of average total assets. The descrip-
tive statistics also indicate that CEOs earn substantially more cash com-
pensation than CFOs (CEO CASHCOMP vs. CFO CASHCOMP ), are older
18 Oler, Shevlin, and Wilson [2007] note that ROA can be decomposed into NI/Sales ×
Sales/TA. We obtain foreign sales data from the Compustat Global database and use domestic
and foreign sales and net income data to calculate a profit margin for each location. Assuming
asset turnover is relatively similar for domestic and foreign operations, we estimate foreign as-
sets by dividing foreign net income by the foreign profit margin times aggregate asset turnover.
For firms with no foreign sales data on the Compustat Global database, we set their percentage
of foreign assets (MNC) to 0.
(CEO AGE vs. CFO AGE), and have much higher mean and median pay-
for-performance sensitivities (CEO SLOPE vs. CFO SLOPE).
Table 3 presents the Pearson and Spearman correlation coefficients
between the TAX RISK measures and several compensation (PAYMIX ,
SLOPE, and RISK INCENT ) and operating volatility (σ (RET) and σ (ROA))
measures. We predict that equity risk incentives motivate managers to un-
dertake risky (but positive NPV) projects, including risky tax avoidance, to
increase stock return volatility and thus the value of their stock option port-
folios. Other studies have examined the relation between tax avoidance and
compensation mix, as measured by the ratio of variable compensation to to-
tal compensation (e.g., Desai and Dharmapala [2006], Armstrong, Blouin,
and Larcker [2010]). Thus, we include CEO and CFO PAYMIX in our cor-
relations for comparison purposes. Panel A presents the correlations for
CEOs, while panel B presents the correlations for CFOs.
The results for the CEO sample in panel A indicate that the TAX RISK
measures are correlated in a predictable manner (i.e., DTAX, SHELTER,
and PRED UTB are positively correlated with each other, but negatively cor-
related with CASH ETR). However, we note that despite their significance,
the correlations between the TAX RISK measures are relatively low. The
largest correlations are between DTAX , SHELTER, and PRED UTB (consis-
tent with these measures capturing similar elements of TAX RISK ), while
the correlations involving CASH ETR are generally the lowest. The low cor-
relations are a reflection of both the noise in our TAX RISK measures and
the fact that each measure likely reflects different aspects of tax avoidance.
Panel A also shows that the TAX RISK measures are positively corre-
lated with CEO PAYMIX , pay-for-performance sensitivity (CEO SLOPE),
and CEO RISK INCENT , and the correlations with CEO RISK INCENT are
the largest in magnitude. These results are consistent with higher CEO
PAYMIX , SLOPE, and RISK INCENT being associated with greater tax
avoidance. We also note that the three compensation variables are all pos-
itively correlated with each other. The correlations between three of the
TAX RISK measures (i.e., DTAX , PRED UTB, and CASH ETR) and the mea-
sures of stock return and ROA volatility (i.e., σ (RET) and σ (ROA)) are,
as predicted, consistent with risky tax avoidance increasing operating and
stock return volatility. In contrast, the correlations between SHELTER and
σ (RET) and σ (ROA) are unexpectedly negative. Untabulated analyses indi-
cate that these negative correlations are due to the large positive correla-
tion between SHELTER and firm size. Holding firm size constant, SHELTER
is significantly positively associated with both volatility measures, consistent
with expectations.19 The results for CFOs in panel B are substantially sim-
ilar to those for CEOs in panel A. Overall, table 3 provides preliminary
evidence consistent with H1.
19 Specifically, in separate ordinary least squares (OLS) regressions of σ (RET) and σ (ROA)
on SHELTER and SIZE, we find negative and significant coefficients on SIZE and positive and
significant coefficients on SHELTER, consistent with aggressive tax sheltering being associated
with greater stock return and ROA volatility, holding firm size constant.
TABLE 3
Pearson (Spearman) Correlations Between Tax Risk, CEO Compensation, and Firm Volatility Measures on the Upper (Lower) Diagonal
DTAX SHELTER CASH ETR PRED UTB CEO PAYMIX CEO SLOPE CEO RISK INC σ (RET) σ (ROA)
Panel A: CEO Sample (N = 18,240)
DTAX 0.09 −0.07 0.19 0.00 0.03 0.07 0.03 0.06
SHELTER 0.09 −0.13 0.27 0.06 0.23 0.43 −0.11 −0.02
CASH ETR −0.08 −0.16 −0.11 0.03 −0.03 −0.11 −0.06 −0.07
PRED UTB 0.24 0.29 −0.09 0.06 0.11 0.21 0.13 0.28
CEO PAYMIX 0.01 0.05 0.02 0.05 0.03 0.11 −0.14 −0.04
CEO SLOPE 0.11 0.33 −0.13 0.20 0.12 0.33 −0.02 −0.01
CEO RISK INC 0.10 0.40 −0.19 0.28 0.23 0.53 −0.09 −0.03
σ (RET) 0.05 −0.13 −0.07 0.09 −0.12 −0.03 −0.09 0.38
σ (ROA) 0.08 −0.01 −0.08 0.26 −0.02 −0.01 0.00 0.40
Panel B: CFO Sample (N = 11,040)
DTAX 0.10 −0.06 0.18 0.00 0.07 0.07 0.01 0.04
SHELTER 0.10 −0.12 0.25 −0.04 0.33 0.38 −0.10 −0.03
CASH ETR −0.07 ‘ −0.12 0.06 −0.08 −0.08 −0.05 −0.06
PRED UTB 0.23 0.28 −0.09 0.03 0.17 0.21 0.11 0.27
CFO PAYMIX −0.01 −0.06 0.07 −0.01 0.11 0.08 −0.08 −0.01
CFO SLOPE 0.10 0.32 −0.15 0.20 0.20 0.75 −0.10 −0.04
CFO RISK INC 0.10 0.33 −0.14 0.24 0.20 0.83 −0.09 −0.05
σ (RET) 0.03 −0.12 −0.07 0.07 −0.07 −0.09 −0.06 0.37
σ (ROA) 0.05 −0.03 −0.05 0.25 0.00 −0.04 −0.01 0.39
∗
Upper (lower) diagonal reports Pearson (Spearman) correlations, and all correlations that are significant at p < 0.10 (two-tailed test) are bolded.
EQUITY RISK INCENTIVES AND CORPORATE TAX AGGRESSIVENESS
793
4.2 RESULTS FOR TWO-STAGE LEAST SQUARES ESTIMATION

We predict that the risk incentive effect associated with stock option com-
pensation motivates managers to increase the firm’s stock return volatility
by undertaking risky projects, including risky tax strategies. We test H1
by estimating our two-equation system (equations 2 and 3), where risky
tax avoidance and equity risk incentives are the endogenous dependent
variables. We predict that the coefficients on CEO RISK INCENT in the
DTAX , SHELTER, and PRED UTB (CASH ETR) regressions should be pos-
itive (negative) and significant.
Table 4 presents results for the system of equations estimated based on
our CEO sample. The coefficients on CEO RISK INCENT in the TAX RISK
regressions (panel A) are all significant in the predicted direction, consis-
tent with H1. These results are consistent with equity risk incentives mo-
tivating CEOs to undertake risky tax strategies that increase stock return
volatility and option portfolio values. Because of our two-stage approach,
these findings imply that, if the exogenous determinants of CEO risk in-
centives change such that they cause CEO risk incentives to increase, we
would also expect to observe an increase in risky tax avoidance, holding
other determinants of risky tax avoidance constant.
To gauge the economic significance of these estimates, we calculate the
effect of a one standard deviation increase in equity risk incentives on risky
tax avoidance. Based on the mean and standard deviation statistics from
table 2 and the standardized coefficient estimates for the TAX RISK regres-
sions in table 4, the effect of a one standard deviation increase in equity
risk incentives is to increase TAX RISK by 28% in the DTAX regression,
by 16.6% in the CASH ETR regression, and by approximately 100% in the
SHELTER and PRED UTB regressions.20 Thus, the effect of equity risk in-
centives on risky tax avoidance appears to be large and economically sig-
nificant, although the magnitudes vary substantially between the DTAX /
CASH ETR and SHELTER / PRED UTB regressions, with the coefficients
on equity risk incentives in the DTAX and CASH ETR regressions provid-
ing the more conservative estimated economic magnitudes.
The results in panel A also indicate that firms with greater CEO pay-
for-performance sensitivity (CEO SLOPE) and higher leverage (LEV ) avoid
more income taxes, while firms with greater capital expenditures (CAPX )
generally avoid less income tax. The significant and positive coefficients on
both CEO RISK INCENT and CEO SLOPE indicate that CEO RISK INCENT
has incremental explanatory power beyond CEO pay-for-performance sen-
sitivity with respect to variation in TAX RISK across firms. The results in
20 To calculate the percentage increase in each TAX RISK measure for a one standard devia-
tion increase in CEO RISK INCENT , we calculate standardized coefficients for each TAX RISK
regression. We then multiply each standardized coefficient on CEO RISK INCENT by the sam-
ple standard deviation of the dependent variable, and then divide by the sample mean of the
dependent variable. For example, the standardized coefficient on CEO RISK INCENT in the
DTAX regression is 0.0936, which we multiply by 0.09 (the standard deviation of DTAX ), and
then divide by 0.03 (the mean of DTAX ), to obtain 28%.
TABLE 4
Results for Two-Stage Least Squares Regressions of Tax Risk Measures and CEO Equity Risk Incentives
Dependent Var → DTAX SHELTER PRED UTB CASH ETR
Independent Var ↓ Sign Coeff t-Stat Sign Coeff t-Stat Sign Coeff t-Stat Sign Coeff t-Stat t-Stat
Panel A: Tax Risk Models
CEO RISK INC + 0.03 2.20∗∗ + 0.70 10.89∗∗∗ + 0.03 20.02∗∗∗ – −0.14 −8.05∗∗∗
CEO SLOPE 0.00 2.72∗∗∗ 0.04 31.74∗∗∗ 0.00 11.10∗∗∗ −0.00 −1.16
PT ROA 0.08 10.07∗∗∗ −0.01 −0.47
NOL −0.00 −0.09 0.05 7.83∗∗∗ −0.00 −2.08∗∗∗ −0.02 −6.15∗∗∗
Log(ASSETS) −0.00 −1.26 −0.00 −4.83∗∗∗
MNC −0.01 −0.87 0.01 2.23∗∗
LEV 0.05 10.48∗∗∗ −0.07 −8.44∗∗∗
R&D −0.16 −8.33∗∗∗ −0.47 −14.09∗∗∗
CAPX −0.14 −9.90∗∗∗ −0.37 −5.73∗∗∗ −0.00 −3.00∗∗∗ −0.26 −10.71∗∗∗
DISC ACCR 0.02 1.82∗ 0.06 4.27∗∗∗
σ (ROA) 0.02 0.73 −0.88 −8.82∗∗∗ 0.04 15.99∗∗∗ −0.09 −1.85∗
# Observations 18,240 18,240 18,140 18,240
Adjusted R 2 17.14% 16.88% 27.75% 14.85%
Dependent Var → CEO RISK INCENT CEO RISK INCENT CEO RISK INCENT CEO RISK INCENT
Independent Var ↓ Sign Coeff t-Stat Sign Coeff t-Stat Sign Coeff t-Stat Sign Coeff t-Stat
Panel B: CEO Risk Incentive Models
TAX RISK + 0.27 1.29∗ + −0.01 −0.24 + 0.54 0.45 − 0.24 2.69
Log(ASSETS) + 0.05 43.07∗∗∗ + 0.05 43.33∗∗∗ + 0.05 43.46∗∗∗ + 0.05 42.41∗∗∗
BTM – −0.05 −6.84∗∗∗ – −0.06 −8.69∗∗∗ – −0.05 −5.16∗∗∗ – −0.06 −11.58∗∗∗
INVESTMENT + 0.03 2.25∗∗ + 0.03 2.28∗∗ + 0.03 2.28∗∗ + 0.04 2.29∗∗
CEO CASH COMP ? 0.05 29.86∗∗∗ ? 0.05 30.08∗∗∗ ? 0.05 30.16∗∗∗ ? 0.05 39.36∗∗∗
CEO AGE ? −0.00 −1.78∗ ? −0.00 −3.16∗∗∗ ? −0.00 −2.74∗∗∗ ? −0.00 −4.06∗∗∗
σ (RET) + 0.02 1.69∗∗ + 0.02 1.69∗∗ + 0.02 1.68∗∗ + 0.02 1.87∗∗
CEO SLOPE + 0.02 26.31∗∗∗ + 0.02 26.57∗∗∗ + 0.02 26.62∗∗∗ + 0.02 25.91∗∗∗
# Observations 18,240 18,240 18,140 18,240
Adjusted R 2 41.16 41.42% 41.60% 40.58%
795
Equations are estimated using two-stage least squares. See appendix A for variable definitions. All regressions include year and two-digit SIC codes effects.
∗ ∗∗
, , and ∗∗∗ denote two-tailed (one-tailed when there is a predicted sign) statistical significance at the 10%, 5%, and 1% level, respectively.
panel A also suggest that firms with net operating loss carryforwards (NOL)
and greater R&D and capital (CAPX ) expenditures have lower CASH ETR,
and firms with higher ROA volatility (σ (ROA)) have higher PRED UTB
and lower CASH ETR. One puzzling result in panel A is the fact that
greater foreign operations (MNC) are associated with less tax avoidance, as
proxied by DTAX and CASH ETR.21 Nonetheless, the estimated coefficients
on CEO RISK INCENT consistently support H1.
Turning to the CEO RISK INCENT regressions in panel B, the coefficient
on DTAX is positive and marginally significant, while the coefficients on
SHELTER, PRED UTB, and CASH ETR are not significant in the predicted
direction. Thus, the results in table 4 suggest that higher CEO equity risk
incentives are associated with more risky tax avoidance, but more risky tax
avoidance is not necessarily associated with higher CEO equity risk incen-
tives. The results in panel B also indicate that larger firms (Log(ASSETS))
with greater investment opportunities (BTM ) and current period invest-
ment activities (INVESTMENT ) provide their CEOs with greater equity risk
incentives. Panel B also suggests that CEOs with greater cash compensation
are provided greater risk incentives, consistent with these managers having
greater risk aversion. After controlling for cash compensation, older CEOs
are provided fewer equity risk incentives. The coefficients on σ (RET) weakly
suggest that firms with higher stock return volatility utilize greater equity
risk incentives. Lastly, as expected, CEO pay-for-performance sensitivity
(CEO SLOPE) (i.e., the change in a manager’s wealth for a given change
in stock price) is positively associated with CEO equity risk incentives.
We present results for our system of equations estimated based on the
CFO sample in table 5. The coefficients on CFO RISK INCENT in the
TAX RISK regressions in panel A are consistent with predictions, although
the coefficient on DTAX is not significant. The coefficients on the control
variables in the TAX RISK regressions are consistent with those in the CEO
sample regressions in table 4. In panel B, the coefficients on the measures
of TAX RISK in the CFO RISK INCENT regressions are not significant in
the predicted direction. Thus, similar to the results for the CEO sample
in table 4, the results for the CFO sample in table 5 suggest that higher
CFO equity risk incentives are associated with more risky tax avoidance,
but more risky tax avoidance is not necessarily associated with higher CFO
equity risk incentives. Overall, the results in tables 4 and 5 provide strong
support for our prediction that equity risk incentives motivate top execu-
tives to increase stock return volatility (and thus the value of their stock op-
tion portfolios) by undertaking risky tax strategies. These results hold even
after controlling for pay-for-performance sensitivity, current and expected
21 Recall that we follow Oler, Shevlin, and Wilson [2007] and estimate the ratio of foreign
assets to total assets. In untabulated robustness tests, we modify MNC to be the ratio of foreign
sales to total sales. The correlation between the two proxies for foreign operations is 85%.
When we re-estimate our system of equations based on the modified MNC variable, we con-
tinue to find that greater foreign operations are associated with less tax avoidance in the DTAX
and CASH ETR regressions.
TABLE 5
Results for Two-Stage Least Squares Regressions of Tax Risk Measures and CFO Equity Risk Incentives
Panel A: Tax Risk Models
CFO RISK INC + 0.11 0.98 + 2.27 4.78∗∗∗ + 0.16 13.21∗∗∗ – −0.53 −4.10∗∗∗
CFO SLOPE 0.01 1.18 0.97 29.97∗∗∗ 0.01 8.71∗∗∗ −0.02 −1.67∗
PT ROA 0.10 8.65∗∗∗ −0.03 −1.24
NOL 0.00 0.81 0.04 4.86∗∗∗ −0.00 −4.12∗∗∗ −0.02 −4.88∗∗∗
Log(ASSETS) −0.00 −0.77 −0.00 −1.55∗
MNC 0.01 1.32 0.00 0.63
LEV 0.05 8.40∗∗∗ −0.07 −6.46∗∗∗
R&D −0.18 −7.25∗∗∗ −0.47 −11.65∗∗∗
CAPX −0.14 −7.22∗∗∗ −0.36 −4.35∗∗∗ −0.01 −3.52∗∗∗ −0.26 −8.78∗∗∗
DISC ACCR 0.02 1.34 0.04 2.26∗∗
σ (ROA) −0.02 −0.51 −0.84 −6.57∗∗∗ 0.04 13.15∗∗∗ −0.06 −0.99
# Observations 11,040 11,040 11,040 11,040
Adjusted R 2 17.39% 18.18% 24.72% 14.28%
Dependent Var → CFO RISK INCENT CFO RISK INCENT CFO RISK INCENT CFO RISK INCENT
Panel B: CFO Risk Incentive Models
TAX RISK + −0.08 −1.67 + −0.01 −1.86 + −0.43 −1.67 − 0.01 0.57
Log(ASSETS) + 0.00 9.80∗∗∗ + 0.00 10.02∗∗∗ + 0.00 10.06∗∗∗ + 0.00 10.23∗∗∗
BTM – −0.00 −0.14 – 0.00 0.50 – −0.00 −0.50 – 0.00 1.49∗
INVESTMENT + 0.01 1.79∗∗ + 0.01 1.82∗∗ + 0.01 1.82∗∗ + 0.01 1.83∗∗
CFO CASH COMP ? 0.07 21.42∗∗∗ ? 0.07 21.66∗∗∗ ? 0.07 21.66∗∗∗ ? 0.07 21.92∗∗∗
CFO AGE ? −0.00 −7.94∗∗∗ ? −0.00 −7.87∗∗∗ ? −0.00 −7.87∗∗∗ ? −0.00 −7.25∗∗∗
σ (RET) + −0.01 −4.15∗∗∗ + −0.01 −4.16∗∗∗ + −0.01 −4.14∗∗ + −0.01 −4.17∗∗∗
CFO SLOPE + 0.26 86.42∗∗∗ + 0.26 87.45∗∗∗ + 0.26 87.46∗∗∗ + 0.26 88.55∗∗∗
# Observations 11,040 11,040 11,040 11,040
Adjusted R 2 63.83% 64.36% 64.37% 64.95%
797
Equations are estimated using two-stage least squares. See appendix A for variable definitions. All regressions include year and two-digit SIC codes effects.
∗ ∗∗
TABLE 6
Results for OLS Regressions of Stock Return Volatility (σ (RET)) on TAX RISK Measures,
CEO RISK INCENT, CEO SLOPE, and Other Control Variables
TAX RISK = TAX RISK = TAX RISK = TAX RISK =
DTAX SHELTER PRED UTB CASH ETR
Coeff t-Stat Coeff t-Stat Coeff t-Stat Coeff t-Stat
Intercept 0.82 73.61∗∗∗ 0.84 74.53∗∗∗ 0.76 67.65∗∗∗ 0.83 74.17∗∗∗
TAX RISK −0.01 −0.53 0.04 9.50∗∗∗ 3.64 21.03∗∗∗ −0.06 −6.31∗∗∗
CEO RISK INC 0.06 9.83∗∗∗ 0.05 8.15∗∗∗ 0.04 6.25∗∗∗ 0.06 9.51∗∗∗
CEO SLOPE 0.01 14.37∗∗∗ 0.01 13.97∗∗∗ 0.01 14.23∗∗∗ 0.01 14.40∗∗∗
CASH COMP −0.00 −0.54 −0.00 −0.75 −0.00 −0.16 −0.00 −0.45
AGE −0.00 −28.35∗∗∗ −0.00 −28.14∗∗∗ −0.00 −26.94∗∗∗ −0.00 −26.94∗∗∗
BTM 0.14 35.48∗∗∗ 0.15 36.45∗∗∗ 0.16 39.91∗∗∗ 0.14 35.81∗∗∗
Log(ASSETS) −0.04 −40.72∗∗∗ −0.04 −41.15∗∗∗ −0.04 −40.82∗∗∗ −0.04 −41.10∗∗∗
INVESTMENT 0.26 20.20∗∗∗ 0.25 19.54∗∗∗ 0.17 13.27∗∗∗ 0.25 19.32∗∗∗
# Observations 18,240 18,240 18,240 18,240
Adjusted R 2 20.40% 20.79% 22.28% 20.57%
All variables are calculated as described in appendix A.
∗ ∗∗
, , and ∗∗∗ denote two-tailed (one-tailed when there is a predicted sign) statistical significance at 10%,
5%, and 1% levels, respectively.
investment opportunities, managerial risk aversion, stock return volatility,

and tax planning opportunities and incentives.
4.3 ESTIMATED WEALTH EFFECTS ASSOCIATED WITH INCREASED TAX RISK
We predict that larger equity risk incentives should motivate managers
to engage in more risky tax avoidance that increases stock return volatility
and option portfolio values. Given the multivariate evidence in tables 4 and
5 that larger equity risk incentives are associated with more risky tax avoid-
ance, we now examine the impact of increased tax risk on manager wealth.
To accomplish this task, we adapt the models of stock return volatility in
Rajgopal and Shevlin [2002] and Coles, Daniel, and Naveen [2006]. In par-
ticular, we use the CEO sample to regress stock return volatility on each
measure of TAX RISK , CEO RISK INCENT , CEO SLOPE, and other control
variables, as follows:
σ (RET ) = β0 + β1 TAX RISK + β2 CEO RISK INCENT + β3 CASH COMP
+ β4 AGE + β5 BTM + β6 Log (ASSETS) + β7 INVESTMENT
+ β8 CEO SLOPE + ε (4)
We then use the estimated coefficients for each TAX RISK measure to cal-
culate the impact of increased tax aggressiveness on stock return volatility
and CEO option portfolio values. We note that these calculations likely con-
tain significant measurement error because we do not know when greater
tax risk translates into higher stock return volatility. Nonetheless, this anal-
ysis provides a rough estimate of the impact of the increased tax risk associ-
ated with larger equity risk incentives on CEO wealth.
Table 6 presents the results for estimations of equation (4), based on
the four different measures of TAX RISK . The results indicate that three of
the four TAX RISK measures are significantly associated with stock return
volatility in the predicted direction (the coefficient on DTAX is not sig-
nificant). The regression models explain approximately 20% of the varia-
tion in stock return volatility. Because the coefficient on SHELTER provides
the estimate of wealth effects that is in between the estimates provided by
PRED UTB and CASH ETR, we focus our discussion on the wealth effects
associated with an increase in SHELTER. We estimate that a one standard
deviation increase in SHELTER increases stock return volatility by 1.6 per-
centage points (0.04 × 0.40 = 1.6%), which translates to an increase in
CEO option values of $211.36 ($76.60) thousand for the mean (median)
sample firm.22 The comparable mean (median) figures for PRED UTB and
CASH ETR are $480.80 ($174.30) thousand and $103 ($37.50) thousand,
respectively. These wealth effects are roughly similar to those estimated by
Rajgopal and Shevlin [2002], who find that a one standard deviation in-
crease in oil and gas exploration risk increases manager wealth by $90.80
($51.83) thousand for the mean (median) sample firm.
5. Supplemental Analyses
5.1 ALTERNATIVE ESTIMATION METHOD
As previously discussed, it is difficult to identify valid instruments for our
system of equations ((2) and (3)), since most firm characteristics that are
significantly associated with tax risk are also associated with equity risk in-
centives, and vice versa. We selected PT ROA and NOL as exogenous vari-
ables for equation (2) and AGE and BTM as exogenous variables for equa-
tion (3), since we expect these variables to exhibit little if any correlation
with the “other” endogenous variable in our system of equations. Nonethe-
less, untabulated correlations between each exogenous variable and the
“other” endogenous variable (e.g., between NOL and RISK INCENT ) indi-
cate small but significant correlations between several exogenous variables
and their respective “other” endogenous variables.
Given the difficulty in identifying valid instruments for our system of
equations, we also adopt an alternative approach and use ordinary least
squares to estimate equation (2). However, to avoid simultaneity bias we
lag CEO and CFO equity risk incentives by one year (LAG CEO RISK and
LAG CFO RISK ) and we include firm and year fixed effects to control for
correlated omitted variables. Coles, Daniel, and Naveen [2006] follow a
similar alternative methodology in their tables 2, 4, and 6. Because our fo-
cus is whether equity risk incentives motivate managers to engage in risky
tax avoidance, we only estimate equation (2), the TAX RISK regression.
Table 7 contains results for ordinary least squares (OLS) regressions
of equation (2) based on the CEO sample, while table 8 contains results
based on the CFO sample. The results in table 7 indicate that lagged CEO
22 To obtain the mean (median) dollar increase in CEO option values, we multiplied the
effect of a one standard deviation increase in SHELTER on stock return volatility (1.6%),
800
TABLE 7
Results for Ordinary Least Squares Regressions of Measures of TAX RISK on Lagged CEO Equity Risk Incentives
LAG CEO RISK + 0.02 3.07∗∗∗ + 0.70 20.74∗∗∗ + 0.01 8.26∗∗∗ – −0.03 −2.19∗∗
LAG CEO SLOPE 0.00 0.54 0.02 4.67∗∗∗ 0.00 1.69∗∗ 0.00 1.18
PT ROA 0.09 4.88∗∗∗ 0.04 1.92∗∗
S. O. REGO AND R. WILSON
NOL 0.01 2.57∗∗∗ 0.09 6.46∗∗∗ 0.00 6.08∗∗∗ −0.03 −7.08∗∗∗

Log(ASSETS) −0.00 −3.72∗∗∗ −0.01 −3.28∗∗∗
MNC 0.03 4.69∗∗∗ −0.01 −1.25
LEV 0.05 4.77∗∗∗ −0.04 −2.54∗∗∗
R&D 0.20 5.07∗∗∗ −0.47 −7.84∗∗∗
CAPX −0.23 −10.9∗∗∗ −0.11 −0.94 −0.02 −5.66∗∗∗ −0.28 −6.88∗∗∗
DISC ACCR −0.04 −2.12∗∗ 0.10 3.79∗∗∗
σ (ROA) 0.04 0.89 −0.29 −1.38∗ 0.08 10.90∗∗∗ 0.01 0.10
# Observations 15,869 15,869 15,869 15,869
Equations are estimated using ordinary least squares. Standard errors are clustered by firm and year. All variables are defined in appendix A.
∗ ∗∗
TABLE 8
Results for Ordinary Least Squares Regressions of Measures of TAX RISK on Lagged CFO Equity Risk Incentives
LAG CFO RISK + 0.04 0.66 + 2.04 7.67∗∗∗ + 0.03 5.30∗∗∗ – −0.02 −0.34
LAG CFO SLOPE 0.02 0.97 0.51 4.27∗∗∗ 0.00 0.23 −0.02 −0.81
PT ROA 0.12 5.81∗∗∗ −0.00 −0.26
NOL 0.01 2.27∗∗ 0.09 5.73∗∗∗ 0.00 4.77∗∗∗ −0.03 −5.61∗∗∗
Log(ASSETS) −0.00 −2.54∗∗ −0.01 −2.81∗∗∗
MNC 0.04 5.57∗∗∗ −0.02 −1.45
LEV 0.05 4.42∗∗∗ −0.04 −2.36∗∗
R&D 0.18 3.89∗∗∗ −0.49 −6.49∗∗∗
CAPX −0.24 −8.34∗∗∗ −0.20 −1.56 −0.02 −7.65∗∗∗ −0.28 −5.93∗∗∗
DISC ACCR −0.05 −1.89∗ 0.08 3.10∗∗∗
σ (ROA) −0.01 −0.19 −0.46 −2.19∗∗ 0.07 7.80∗∗∗ 0.08 0.73
# Observations 8,886 8,886 8,886 8,886
Equations are estimated using ordinary least squares. Standard errors are clustered by firm and year. All variables are defined in appendix A.
∗ ∗∗
801
equity risk incentives (LAG CEO RISK ) are significantly associated with all
four measures of TAX RISK in the predicted direction. However, the coef-
ficients on the control variables differ somewhat from those in table 4. We
continue to find that firms with higher leverage (LEV ) and greater R&D
and capital expenditures (CAPX ) have lower CASH ETR, while firms with
higher PT ROA and LEV have higher DTAX . However, lagged CEO pay-for-
performance sensitivity (LAG CEO SLOPE) is significantly associated with
SHELTER and PRED UTB but not DTAX or CASH ETR. Nonetheless, the
results in table 7 for lagged CEO equity risk incentives are uniformly con-
sistent with H1 and the results for CEO RISK INCENT in table 4, panel A.
In contrast, the results in table 8 indicate that lagged CFO equity risk
incentives (LAG CFO RISK ) are significantly associated with just two mea-
sures of TAX RISK (i.e., SHELTER and PRED UTB). Taken together, the
results in tables 7 and 8 indicate that the positive relation between CEO
equity risk incentives and tax risk is more robust than the positive relation
between CFO equity risk incentives and tax risk, consistent with CEO equity
risk incentives having greater influence over corporate tax risk taking.
5.2 CORPORATE GOVERNANCE, TAX AVOIDANCE, AND MANAGERIAL

RENT EXTRACTION
The tax literature has traditionally assumed that tax planning increases
firm value (e.g., Crocker and Slemrod [2005]). In contrast, Desai and
Dharmapala [2006] theorize that complex tax avoidance obscures financial
reporting and facilitates managerial rent extraction, which can decrease firm
value. They argue that this positive relation between complex tax avoid-
ance and managerial rent extraction is most likely to be present at firms
with weak corporate governance. Consistent with their theory, Desai and
Dharmapala [2006] provide evidence that firms with weak corporate gov-
ernance but greater incentive compensation avoid less income tax. They
conjecture that greater incentive compensation at poorly governed firms
more closely aligns managers’ incentives with those of shareholders, which
reduces managerial rent extraction through complex tax strategies. Other
studies find evidence that tax avoidance increases firm value, but only at
well-governed firms (e.g., Desai and Dharmapala [2007], Wilson [2009]).
Taken together, these studies suggest that strength of corporate governance
moderates corporate tax practices.
We build on prior research and examine whether the positive relation
between equity risk incentives and risky tax avoidance shown in tables 4–8
varies by strength of corporate governance. Desai and Dharmapala [2006,
2007] and Wilson [2009] measure corporate governance strength based
on the Gompers, Ishii, and Metrick [2003] index of shareholder rights
(G-INDEX ). We assert that managerial entrenchment is the governance
by the mean (median) value for CEO RISK INCENT ($132.10 ($47.90)), to obtain the mean
(median) effect on CEO option values of $211.36 ($76.60) thousand. We performed similar
calculations for PRED UTB and CASH ETR, as well.
construct most consistent with Desai and Dharmapala’s [2006] theory that
tax sheltering and managerial rent extraction are complementary activi-
ties at poorly governed firms. Mann [1965] maintains that managerial en-
trenchment can hurt shareholders by insulating managers from the threat
of removal, thereby increasing the likelihood of shirking, empire building,
and the extraction of private benefits. We utilize several proxies for man-
agerial entrenchment, including: (1) Bebchuk, Cohen, and Ferrell’s [2008]
index of managerial entrenchment (E-INDEX ), (2) the Gompers [2003]
index of shareholder rights (G-INDEX ), and (3) an indicator variable for
whether the CEO is also the chairman of the board (CEO IS CHAIR). For
ease of exposition, we only tabulate results when WEAK GOV is measured
by E-INDEX and disclose in the text when results differ for G-INDEX and
CEO IS CHAIR.
Desai and Dharmapala [2006, 2007] interact corporate governance met-
rics with their variables of interest to examine whether corporate gover-
nance strength moderates corporate tax practices. Such interactions are
problematic when they involve endogenous variables in systems of equa-
tions. Thus, we examine whether corporate governance strength moderates
corporate tax avoidance by following the alternative estimation method de-
scribed above (i.e., OLS regressions of TAX RISK on LAG CEO RISK and
LAG CFO RISK ). This estimation method allows the corporate governance
metrics to be interacted with other variables while avoiding simultaneity
bias. In particular, we use the CEO and CFO samples to separately estimate
the following equation and test whether corporate governance strength
moderates the relation between CEO and CFO equity risk incentives and
risky tax avoidance:
TAX RISK = α1 WEAK GOV + α2 LAG RISK INCENT + α3 LAG RISK
× WEAK GOV + α4 LAG SLOPE + α5 LAG SLOPE
× WEAK GOV + α6 PT ROA + α7 NOL + α8 Log(ASSETS)
+ α9 MNC + α10 LEV + α11 R&D + α12 CAPX + α13 DISCR ACCR
+ α14 σ (ROA) + α15 YEAR + α16 INDUS + ε (5)
WEAK GOV is an indicator variable based on E-INDEX , G-INDEX , and

CEO IS CHAIR. In particular, WEAK GOV equals one when E-INDEX is
greater than 3, when G-INDEX is greater than 8, and when the CEO is
also the chairman of the board of directors, and equals zero otherwise.23
23 The E-INDEX is an index of six anti-takeover provisions from bylaws and charter amend-
ments identified by Bebchuck, Cohen, and Ferrell [2008]. Low scores indicate a lower degree
of insulation for managers and therefore higher quality corporate governance. The Gompers,
Ishii, and Metrick [2003] index of shareholder rights (G-INDEX ) is based on 24 different pro-
visions, which can be classified into five categories—tactics for delaying hostile bidders, voting
rights, director and officer protection, other takeover defenses, and state laws. Each of these
categories represents potential determinants of a firm’s takeover vulnerability. Consistent with
E-INDEX , lower scores for G-INDEX indicate higher quality corporate governance.
(See appendix A for complete variable definitions.) If complex tax avoid-

ance facilitates managerial rent extraction at weakly governed firms, but
greater incentive alignment reduces such managerial rent extraction (con-
sistent with Desai and Dharmapala’s [2006] theory), then we expect the
coefficient on LAG RISK×WEAK GOV to be negative.
Table 9 contains a summary of results for OLS estimations of equation
(5) based on the CEO (panel A) and CFO (panel B) samples. We only
present coefficient estimates for WEAK GOV , CEO and CFO equity risk in-
centive (RISK INCENT ) and pay-for-performance (SLOPE) variables, and
their interactions with WEAK GOV . In sum, the results in table 9 provide
little evidence that the positive relation between equity risk incentives and
risky tax avoidance systematically varies by strength of corporate gover-
nance. While the coefficients on lagged CEO and CFO equity risk incen-
tives continue to be qualitatively similar to those in tables 7 and 8 (and thus
support H1), none of the coefficients on LAG CEO RISK × WEAK GOV
are significant in panel A (CEO sample). In panel B (CFO sample), only
the coefficient on LAG CFO RISK × WEAK GOV in the DTAX regression is
weakly significant in the predicted direction.24 We conclude that the posi-
tive relation between equity risk incentives and risky tax avoidance does not
systematically vary by strength of corporate governance.25
6. Conclusion
Despite the increase in aggressive tax shelter strategies during the 1990s
and early 2000s, little is known about the links (if any) between CEO and
CFO compensation practices and aggressive tax avoidance. Based on Guay’s
[1999] theory of equity risk incentives, we predict that equity risk incentives
motivate managers to undertake risky tax strategies that increase stock re-
turn volatility and option portfolio values. We test our predictions by utiliz-
ing three existing measures of tax avoidance, including discretionary book-
tax differences, tax shelter prediction scores, and cash ETRs. We also esti-
mate the amount of UTBs that sample firms have accrued under Interpreta-
tion No. 48 (FIN 48) and use this amount as our fourth measure of tax risk.
24 When we substitute G-SCORE or CEO IS CHAIR for E-INDEX as alternative measures of
weak governance in equation (4), the interaction term of interest (LAG RISK×WEAK GOV)
is only significant in the predicted direction in one of eight alternative specifications for the
CEO sample. Specifically, the interaction term is significant when CEO IS CHAIR is the cor-
porate governance measure and CASH ETR is the proxy for tax risk. The interaction term is
insignificant in the other seven specifications. The interaction term is also only significant in
the predicted direction in one of the eight alternative specifications for the CFO sample, i.e.,
when PRED UTB is the proxy for tax risk and G-SCORE is the corporate governance measure.
Results are not tabulated.
25 We cannot eliminate the possibility that we do not find systematic variation by strength
of corporate governance because we have weak corporate governance proxies. But, given the
relative consistency of the coefficients on LAG RISK×WEAK GOV across three different mea-
sures of corporate governance (and four different measures of TAX RISK ), we believe the best
interpretation of our results is that the relation between equity risk incentives and corporate
tax avoidance does not vary by strength of corporate governance.
TABLE 9
Summary of Results for Ordinary Least Squares Regressions of Tax Risk on Lagged CEO and CFO Equity Risk Incentives, Corporate Governance Strength, and Their Interaction
Panel A: Lagged CEO Risk Incentives Interacted with Corporate Governance Strength
LAG CEO RISK + 0.02 3.31∗∗∗ + 0.71 21.36∗∗∗ + 0.01 8.14∗∗∗ – −0.04 −2.26∗∗
LAG CEO SLOPE 0.00 0.36 0.02 4.62∗∗∗ 0.00 1.62 0.00 1.11
WEAK GOV −0.01 −2.41∗∗ 0.01 0.48 −0.00 −1.37 0.00 0.27
LAG CEO RISK × WEAK GOV – 0.00 0.24 – −0.07 −0.48 – 0.00 0.29 + 0.01 0.34
LAG CEO SLOPE × WEAK GOV 0.00 0.37 0.01 0.90 −0.00 −0.45 0.01 1.87∗
# Observations 15,776 15,776 15,776 15,776
Panel B: Lagged CFO Risk Incentives Interacted with Corporate Governance Strength
LAG CFO RISK + 0.05 1.05 + 2.11 7.59∗∗∗ + 0.03 5.45∗∗∗ – −0.02 −0.29
LAG CFO SLOPE 0.01 0.83 0.50 4.41∗∗∗ 0.00 0.09 −0.02 −0.71
WEAK GOV −0.01 −3.48∗∗∗ −0.00 −0.02 −0.00 −2.51∗∗ 0.01 0.82
LAG CFO RISK × WEAK GOV – −0.23 −1.73∗∗ – −0.71 −0.72 – −0.01 −0.47 + −0.01 −0.07
LAG CFO SLOPE × WEAK GOV 0.11 1.45 0.03 0.07 0.01 0.62 −0.03 −0.51
# Observations 8,840 8,840 8,840 8,840
Equations are estimated using ordinary least squares. Standard errors are clustered by firm and year. WEAK GOV is an indicator variable set equal to one for firms with an E-INDEX
of greater than 3. E-INDEX is a measure of managerial entrenchment from Bebchuck, Cohen, and Ferrell [2008]. All other variables are defined in appendix A.
∗ ∗∗
805
Our results consistently indicate that greater equity risk incentives are as-
sociated with higher tax risk; however, higher tax risk does not necessarily
imply greater equity risk incentives. Our results for CEOs are highly robust
to alternative estimation methods (i.e., simultaneous system of equations vs.
OLS with lagged instrumental variable), and we find little evidence that cor-
porate governance strength moderates the positive relation between equity
risk incentives and risky tax avoidance. However, we find some evidence
that the positive relation between equity risk incentives and tax risk for
CFOs is less robust than that for CEOs, consistent with CEO equity risk
incentives having greater influence over corporate tax risk taking.
Our study extends prior research that investigates whether equity risk in-
centives motivate managers to undertake risky projects, including investing
and financing decisions (e.g., Guay [1999], Rajgopal and Shevlin [2002],
Coles, Daniel, and Naveen [2006]), and complements studies that inves-
tigate the link between ETRs, tax sheltering, and executive compensation
practices (e.g., Phillips [2003], Desai and Dharmapala [2006], Armstrong,
Blouin, and Larcker [2010]). Our results suggest a need for future research
that directly investigates whether—and in which contexts—tax avoidance
is conducive to managers extracting rents from the firm. Lastly, our study
complements results in Dyreng, Hanlon, and Maydew [2010], which finds
that CEOs, CFOs, and other top managers have a significant impact on both
GAAP and cash ETRs. Our findings offer at least one reason why individual
CEOs and CFOs decide to engage in aggressive tax planning: to increase
option portfolio values through greater managerial risk taking.
APPENDIX A
Variable Measurement
TAX RISK Measures:

CASH ETR = The five-year sum of cash taxes paid (TXPD) ending in year t divided
by the five-year sum of pretax income (PI) less special items (SPI)
ending in year t.
SHELTER = An indicator variable set equal to 1 for firms in the top quintile of the
predicted probability the firm is engaged in tax sheltering based on
model from Wilson (2009):
SHELTER = −4.30 + 6.63 × BTD − 1.72 × LEV + 0.66 × SIZE
+ 2.26 × ROA + 1.62 × FOR INCOME + 1.56 × R&D
DTAX = Residual from the following regression estimated by year and two-digit
Standard Industrial Classification (SIC) code:
PERMDIFF it = α0 + α1 (1/AT it−1 ) + α2 INTANG it
+ α3 UNCON it + α4 MI it + α5 CSTE it + α6 NOL it
+ α7 LAGPERM it + εit
where:
PERMDIFF = Total book-tax differences – temporary book-tax
differences = [{PI – [(TXFED + TXFO) / STR]} – (TXDI /STR)],
scaled by beginning of year assets (AT);
STR = Statutory tax rate;
INTANG = Goodwill and other intangibles (INTAN) divided by total
assets at year t – 1;
UNCON = Income (loss) reported under the equity method (ESUB)
divided by total assets at year t – 1;
MI = Income (loss) attributable to minority interest(MII), scaled by
beginning of year assets (AT);
CSTE = Current state tax expense (TXS), scaled by beginning of year
assets;
NOL = Change in net operating loss carry forwards (TLCF), scaled by
beginning of year assets (AT);
LAGPERM = PERMDIFF in year t – 1.
PRED UTB = Predicted unrecognized tax benefits at the end of year t. Calculated
based on the estimated coefficients (see table 1) from the following
prediction model:
UTB it = α0 + α1 PT ROAit + α2 SIZE it + α3 FOR SALEit
+ α4 R&D it + α5 LEV it + α6 DISC ACCRit + α7 SG&Ait
+ α8 MTB it + α9 SALES GR it
TAX RISK Model Variables:
CEO RISK INCENT = The sensitivity of the change in the Black–Scholes option value for a
1% change in stock return volatility, multiplied by the number of
options in the CEO’s portfolio (see Guay [1999]).
PT ROA = PI, scaled by beginning of year total assets (AT).
Log(ASSETS) = Natural log of total assets (AT).
MNC = An estimate of foreign assets based on methodology described in Oler,
Shevlin, and Wilson [2007].
σ (ROA) = Standard deviation of annual PI over the prior four years ending in
year t.
LEV = Total debt (DLTT + DLC) scaled by beginning of year total assets
(AT).
CAPX = Capital expenditures (CAPX) scaled by beginning of year total assets
(AT).
R&D = Research and development expense (XRD) scaled by beginning of
year total assets (AT).
DISC ACCR = Discretionary accruals calculated using performance-adjusted
modified Jones model. We first estimate the following cross-sectional
regression by two-digit SIC industry and year.
TACCR it = α0 + α1 1/AT it + α2 SSAit
+ α3 SPPENT it + α4 ROAit + εi
where:
TACCR = Total accrual using cash flow approach;
SSA = Change in sales minus change in accounts receivable;
SPPENT = Net value of property plan and equipment;
ROA = Return on assets.
RISK INCENT Model Variables:

BTM = Book to market ratio calculated as total common equity (CEQ)
divided by the common shares outstanding (CSHO) multiplied by the
stock price at year end (PRCC F).
INVESTMENT = Total investments, calculated as the sum of research and development
expenditures (XRD), acquisitions (AQC), and net capital
expenditures (i.e., capital expenditures (CAPX) less sales of property,
plant, and equipment (SPPE)) divided by average total assets (AT).
CEO CASHCOMP = The sum of the CEO’s salary and bonus compensation.
CEO AGE = The CEO’s age.
σ (RET) = Annualized standard deviation of daily stock returns.
CEO SLOPE = 1% × (share price) × (number of shares held) + 1% × (share price)
× (option delta) × (number of options held); see Core and Guay
[1999] for the computation of the option delta.
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DOI: 10.1111/j.1475-679X.2012.00438.

Equity Risk Incentives and

Received 13 July 2011; accepted 21 November 2011

This study examines equity risk incentives as one determinant of corporate

The benefits of aggressive tax positions are straightforward. They reduce

If equity risk incentives generally mitigate the risk-related incentive prob-

2. Background and Hypothesis Development

2.2 LINKING CORPORATE COMPENSATION PRACTICES TO TAX AVOIDANCE

[2005] develop a theoretical model of the contractual relationship be-

is driven by weaker-governed firms.8 They conclude that incentive compen-

variable compensation includes bonus, restricted stock, and stock options.

effect motivates managers to undertake positive net present value projects,

13 Moreover, it seems relatively straightforward that tax directors’ compensation should be

RISK INCENT = β1 TAX RISK + β2 CASH COMP + β3 AGE + β4 BTM

As previously discussed, our four proxies for risky tax avoidance

4. Data and Discussion of Empirical Results

leverage (LEV ), research and development expenditures (R&D), selling

4.2 RESULTS FOR TWO-STAGE LEAST SQUARES ESTIMATION

investment opportunities, managerial risk aversion, stock return volatility,

NOL 0.01 2.57∗∗∗ 0.09 6.46∗∗∗ 0.00 6.08∗∗∗ −0.03 −7.08∗∗∗

5.2 CORPORATE GOVERNANCE, TAX AVOIDANCE, AND MANAGERIAL

WEAK GOV is an indicator variable based on E-INDEX , G-INDEX , and

(See appendix A for complete variable definitions.) If complex tax avoid-

24 When we substitute G-SCORE or CEO IS CHAIR for E-INDEX as alternative measures of

TAX RISK Measures:

RISK INCENT Model Variables:

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