Journal of Accountmg and Economics 5 (1983) 119-149.

North-Holland

TAXES AND FIRM SIZE*

Jerold L. ZIMMERMAN
University of Rochester, Rochester, NY 14627, USA

Received Apt-111983, final verston received June 1983

Firm size has been used as a proxy for the firm’s political costs and hence managers’ proclivity
to choose income reducing accounting procedures. Thts study provides additional evidence on
this topic by examining the association between firm size and effective corporate tax rates. The
latter are one component of a firm’s political costs. The roughly ftity largest U.S. exchange-listed
firms, in particular od and gas companies and manufacturing firms, have significantly higher
worldwide tax rates than other firms. These higher tax rates-are observed pmrtmanly after- the
imdementation of the U.S. 1969 Tax Reform Act and after the OPEC countries raised theu tax
ratis on U.S. oil producers. The findings, which are insensitive to alternative sources of data,
alternative measures of firm size, and alternative measures of effective tax rates, are consistent
wtth the use in previous studies of firm size as a proxy for the firm’s political costs.

1. Introduction
Previous accounting studies hypothesized that large firms are subjected to
greater government scrutiny and wealth transfers than smaller firms and
therefore to reduce these political costs, large firms choose income reducing
accounting procedures more frequently than small firms. The evidence is
generally consistent with this ‘political cost hypothesis’.’
Corporate taxes are one component of political costs. Observing the
largest firms having the highest effective tax rates is consistent with the
political cost hypothesis. An ‘effective tax rate’ is the ratio of taxes paid to
*The comments of participants at workshops at Stanford University, Baruch College, SUNY-
Buffalo and the Umversity of Rochester are gratefully acknowledged, especially those from
George Benston, Dean Crawford, Harry DeAngelo, Linda DeAngelo, George Foster, Robert
Hagerman, Robert Holthausen, Michael Jensen, Richard Left&h,. Jam& Patell, -Richard
Ruback. Ronald Schmidt, Dennis Sheehan, Clifford Smith. Lee Wakeman. Jerold Warner. James
Wheeler, Mark Wolfson,.the referee, Eugene Fama, and in particular, Ross Watts. This research
was supported by the Center for Research in Government Policy and Business, Graduate School
of Management, The University of Rochester.
‘Al&an and Kessel (1962) and Jensen and Meckhng (1978) hypothesize that large firms are
subjected to greater government scrutiny than smaller firms. Numerous accounting studies have
exammed the assocratron between firm size and choice of accounting procedures: Gagnon (1967,
1971), Watts (1977), Watts and Zimmerman (1978, 1979), Hagerman and Zmqewski (1979),
Zmijewskt and Hagerman (1981), Leftwich (1981), Colhns, Rozetf and Dhahwal (1981),
Holthausen (1981), Bowen, Noreen and Lacey (1982), Lihen and Pastena (1982) and Dhaliwal,
Salamon and Smith (1982). Also, see Holthausen and Leftwich (1983) and Watts and
Zimmerman (1983, chs. 11 and 12) for a review of the literature.

0165-4101/83/$3.00 0 1983, Elsevter Science Publishers B.V (North-Holland)

120 J.L. Znnmerman, Taxes and firm me

pretax income or operating cashflows. While all corporations face the same
marginal federal tax rate schedule, numerous tax provisions like the
investment tax credit and oil depletion allowance cause firms’ effective tax
rates to vary across firms and industries.* This variation in effective
corporate tax rates provide a partial measure of a firm’s success in the
political process and as such provides evidence regarding the associations
between firm size, industry classification and political costs.3
Effective corporate tax rates are only a partial measure of the firm’s
political costs because tax rates exclude other political costs/benefits, such as
antitrust, regulation, government subsidies and contracts, import quotas and
tariffs. Therefore, an association between effective tax rates and firm size
implies that large firms incur higher costs via the political process only if it is
assumed that the non-tax components of political costs do not offset the tax
components.
Besides being a component of political costs, effective tax rates act as a
proxy for current and future political costs to the extent that effective tax
rates and the firm’s success are positively associated and successful firms are
subjected to greater government scrutiny. The largest firms tend to be the most
successful and have higher effective tax rates because their tax shields, interest
and depreciation, are fixed. If two firms have the same assets and liabilities,
the more successful (i.e., profitable) firm has a higher ratio of taxes to
operating cashflows than the other firm. Therefore, the U.S. government
taxes successful firms more heavily than less successful firms. Moreover, if the
political process subjects successful firms to greater government scrutiny than
less successful firms, effective corporate tax rates act as proxies for the
political costs the firm incurs due to the additional government scrutiny.
The two preceding non-mutually exclusive reasons are consistent with the
political cost hypothesis tested in the accounting choice/lobbying studies.
But, they differ in the direction of the causality. The first reason assumes that
the high tax rates are a component of the total political costs incurred by the
firm and they result from explicit wealth redistributions by the political
process. The second reason assumes that high effective tax rates are a proxy
for corporate success which leads to greater government scrutiny and
regulation.
This paper examines the association between firm size, industry classifica-
tion, and effective tax rates. The results are generally consistent with the
political cost hypothesis; the largest firms have the highest effective tax rates
in most but not all industries. The oil and gas industry has the strongest
relationship between firm size and tax rates, and manufacturing a weaker
*Currently, all firms with pretax income greater than $100,000 have a statutory margmal tax
rate of 46X. Since this study focuses on large listed firms, all the firms in the study have the
same expe&d statutory mar-gmaf federal taxrate. The firms m thrs study are so large-relative to
the breakpoints on the margmal tax schedule that the effect of progresstvtty IS neghgrble.
Wus argument assumes that firms do not fully offset then ddferenttal effective tax rates by
substttuting among other tax shields (e g.. debt). See DeAngelo and Masuhs (1980, p 24)
 J.L Zzmmerman, Taxes andfirm size 121

association. In the wholesale and retail trade industry the opposite result is
found. The large trade firms have lower effective tax rates than small trade
firms. These industry results are similar to and reinforce the findings of the
accounting choice studies. The strongest association between firm size and
choice of accounting procedures is in the oil and gas industry [Watts and
Zimmerman (1978) and Bowen, Noreen and Lacey (1981)] and in this study
the oil industry has the strongest association between size and tax rates. The
trade industry is inconsistent with the political cost hypothesis in both the
accounting choice studies and in this study of effective tax rates.4
Also supporting previous accounting choice studies, this paper finds that
corporate tax rates do not increase in firm size monotonically. Rather they
are uniform across size categories except for roughly the largest fifty
companies, which have the highest tax rates. This threshold effect is
consistent with prior findings by Watts and Zimmerman (1978) and
Zmijewski and Hagerman (1981). Another finding of this paper is that
financial statement data and IRS data produce similar effective corporate tax
rates. This suggests that financial statement data yield unbiased estimates of
effective tax rates.
These results reinforce the earlier accounting studies that used firm size as
a proxy for political costs thereby mitigating some of the criticisms of these
studies. In particular, firm size as a proxy for political costs was questioned
because size is associated with numerous other factors, principally industry
classification [Ball and Foster (1982)]. By not explicitly controlling for
industry, Ball and Foster suggest that incorrect inferences regarding political
costs and accounting choices may result. The findings in this paper suggest
that size is still an important variable after controlling for industry. Also,
Holthausen and Leftwich (1983) raise the issue of interpreting the association
between firm size and choice of accounting procedures given the early and
incomplete development of the economic theory of the political process.
Their concern also applies to this study, but the additional and consistent
nature of the evidence in this study reduces the likelihood that the
association between firm size and accounting choices occurred by chance or
is the result of industry-specific differences in accounting procedures.
Other studies have examined the associations between effective corporate
tax rates, firm size and industry classification.’ These studies typically use

4Watts and Zimmerman (1978) report four out of thirty-four firms m their sample as bemg
mis-classified. Two of the four are from the trade industry - the only two trade firms m the
sample. Likewise, results m Bowen, Noreen and Lacey (1981, table 2) indicate that the large
manufacturing and 011 firms are consistent with then theory (i.e., more hkely to choose an
income decreasing accounting method). But large firms m the trade industry (SIC code # 5) are
mconsistent with their predictions (large firms choose the mcome increasing method) Therefore,
in two accounting choice studies and m this study, trade firms are consistently inconsistent wtth
the theory.
5A representatrve but non-exhaustive set of papers mcludes Weiss (1979), U.S. Treasury (1978),
Ftekowsky (1977), Cordes and Shefrm (1983), Siegfned (1974), Sttckney and Tower (1978), and
Sttckney and McGee (1982).
122 J.L. Zimmerman, Taxes andfirm me

only one definition of effective tax rates and a few years of data to examine
tax rates across industries. The data for these studies are drawn from either
corporate financial statements or aggregate IRS tax returns. No study
compares the estimated time series of tax rates from both data sources cross-
sectionally by both industry and firm size.
Several alternative definitions of effective tax rates are used in this study to
compare the time series and cross-sections by industry and size of firm. Tax
rates are calculated using data from both corporate financial statements and
tax returns. This helps ensure that any observed associations are not the
result of cross-sectional differences in financial accounting procedures. Time
series and cross-sectional analyses of financial statement data are reported in
section 2. Section 3 reports the analysis of IRS data. Section 4 discusses the
implications and limitations of the findings.

2. Time series and cross-sectional analyses of firm-specific data

There are two primary sources of data on corporate taxes: aggregate
statistics published by the IRS and firm-specific data from financial
statements. There are advantages and disadvantages to both sources
[Fiekowsky (1977) and Weiss (1979)]. Firm-specific data from
COMPUSTAT are the most convenient to use and allow the researcher
more control over the composition of the sample (i.e., more powerful tests
can be constructed). The disadvantage of using financial statement data is
that due to differences in accounting treatment for tax and financial
reporting, tax expense as reported on the financial statements is not
equivalent to the firm’s tax liability as reported to the IRS.
Differences between tax and financial accounting create measurement error
that may be systematically related to firm size. A detailed examination of
these errors is beyond the scope of this study. The approach taken here is
first an analysis in this section of the COMPUSTAT data including a
sensitivity analysis. Second, some of the tests are repeated in the next section
using IRS data to ensure that the differences in tax rates are not the result of
financial accounting procedures. This section finds that the roughly fifty
largest firms have higher effective tax rates, that these tax rates do not
increase monotonically with firm size, and that the results are strongest for
the large oil companies in the 1970’s. Large trade firms show just the
opposite result - they have lower effective tax rates than smaller trade firms.
The results are not sensitive to alternative measures of size and alternative
methods of calculating tax rates.
2.1. Data
Effective tax rates are calculated as

Income taxesfoperating cashflows.

 .I L. Zimmerman, Taxes andjrm sue 123

This ratio corresponds to the effective tax rates used in other studies [Fama
(1981) and Gonedes (1981)]. Income taxes are measured as state, U.S. and
foreign reported income tax expense less the change in deferred taxes.6 This
calculation is a proxy for the firm’s total worldwide income tax liability for
the year. A measure of operating cashflows (as opposed to earnings) is used
in the denominator because it excludes the effects of accrual accounting
procedures, which vary with firm size [Hagerman and Zmijewski (1979)].
Operating cashflows are measured by the difference between sales and cost of
goods sold.7 Other casMow adjustments (e.g., selling and administrative
expenses) are not made to the denominator in order to maintain
comparability to the IRS data analyzed in the next section. This measure of
cashflows will impart systematic differences in estimated tax rates across
industries due to different capital structures and capital-labor ratios.
However, the differences within industries should be less severe.
The data used in this section are two COMPUSTAT tapes spanning the
period 1946-1981. The first tape, a merged tile of several earlier tapes, is used
for 19461970. The 1982 COMPUSTAT tape is used for 1971-1981. The first
year, 1946, is lost in differencing the deferred tax account. An observation is
generated if the company reported sales and tax expense in any year. This
process yields 50,454 firm-year observations covering the thirty-five years,
1947-1981.

Observations are then deleted for three reasons:

(i) cost of sales is missing (this eliminated financial institutions);

(ii) sales less cost of sales is negative or tax expense is negative; or
(iii) the estimated tax rate exceeds 2.0.

The first constraint is required to estimate cashflows from operations. The

second constraint eliminates observations that do not represent the actual
%rbtracting the change in deferred taxes is an approximate adjustment for the temporary
timing differences between tax and book accrual accountmg. For example, consider a firm with
SlOO of before tax and depreciation income and a tax rate of 30%. Depreciation per books ts
$60 and per the tax return is $70. Reported tax expense IS $12 whereas the tax liability ts S9.
The deferred tax account changes by $3 Subtracting this change from reported tax expense of
$12 produces the income tax hability. While in this simple example the tax liability can be
mferred from the financial statements, m reality there IS usuallv not enouah information to
control for early retirements of plant and equipment, deferred taxes in current habthties, etc.
‘CashSow from operations (COMPUSTAT data ttem # 110) is not used because it is only
available since 1971. The COMPUSTAT data items used are
Income taxes = item # 16 -change in item # 35,
Operatrng cashtows=item #12-item #41.
If large firms have proportionately more deprectable assets, then using the denommator (sales
less cost of goods sold) biases the large firms’ effecttve tax rates by excludmg the costs of
investments (e.g., depreciation). The tests were repeated using the followmg denominators: (i)
pretax mcome (which includes deprectation), (u) sales less cost of goods sold less depreciation,
and (iii) operating income before depreciation. The Inferences were unaffected by these
alternative denominator measures.
124 J.L. Zimmerman, Taxes and jrm size

tax liability in the year. If the firm reports a loss, the reported tax expense is
a mixture of the current period refund and estimated tax carryforwards and
carrybacks. Including estimated tax rates from years with negative operating
casMow adds noise to the data and reduces the power of the tests. The third
constraint eliminates extreme or meaningless values that can dominate the
results. Estimated tax rates can exceed one due to data errors or due to tax
gain carryforwards (e.g., the tax expense on an asset sold in a prior year for a
gain is recognized in the current period, thereby distorting the numerator of
the estimated tax rate but not the denominator). No more than four
observations per year are deleted due to the third constraint. Alternative
constraints of 1.0 and 0.75 were also used and they produced the same
results as those reported. The above three data constraints reduced the final
sample size to 43,515 observations.
In the first set of tests the distribution of sales was examined each year and
the roughly largest fifty firms were coded as ‘large’ and all other firms were
coded as ‘other’.’ This dichotomous measure of size based on sales was
chosen because previous research [Watts and Zimmerman (1978) and
Zmijewski and Hagerman (1981)] indicates that only the very largest firms
face differential political costs. The choice of fifty firms is arbitrary. If fifty is
too many (or too few), the tests are biased against rejecting the null
hypothesis of no association between size and tax rates. This procedure was
also used to allow comparability of the COMPUSTAT results with the IRS
data, which classifies firms into portfolios.

2.2. Time series results

Once each firm is classified in each year into either a ‘large’ or ‘other’
portfolio, the average cross-sectional effective tax rate is computed for each
portfolio for each year. Fig. 1 is the time series plot of the cross-sectional
averages for the two portfolios. The ‘large’ firms have higher effective tax
rates in twenty of the thirty-live years and in every year since 1970. These
results are inconsistent with the political cost hypothesis (binomial test yields
2=0.84, H,:p=OS, one-sided test). Average effective tax rates in the ‘other’
portfolio have fallen from 27% of operating cashflows during the Korean
War to about 12% in 198&81. The ‘large’ portfolio tax rates also fell from a

sThe following procedure was used to dichotomtxe firms into the ‘large’ and ‘other’ portfolios.
By examimng the 90, 95 and 99 percenttles of the dtstribution of firms’ sales on COMPUSTAT
each year, a sales cut-off was chosen that would yield roughly 50 firms above this cut-off. The
cut-off was calculated by extrapolating the sales between the two closest percenttles
corresponding to the percenttle of the fiftieth largest firm. Fums wtth sales equal to or larger
than the cut-off were classdied as ‘large’ and tirms smaller than the cut-off were classified as
‘other’. Then, firms were deleted from both portfohos for any of the three prevtously descrtbed
deletton criteria. This procedure yielded a ‘large’ portfoho contaming roughly 50 firms, although
in some years it was as few as 37 firms and in other years rt was as many as 72 tirms, depending
on data availabthty.
 J.L. Zimmerman, Taxes andfirm size 125

high of 28% during the 1950’s to about 14% in the late 1960’s, but in the
1970’s they increased to between 15-20x. The general decline in tax rates
since the 1950’s is consistent with other studies [New York Stock Exchange
(1982) and Fama (1981)]. .

Tax Rate
0.30 -

0.25 -

0.20 -

0.15 - Large Firms

Other Firms

0.10
45 50 55 60 65 70 75 60
Year

Fig. 1. Mean effectwe tax rates on casbilows of the largest firms and all other firms on
COMPUSTAT, 1947-1981; firm size IS measured by sales.

The ‘other’ portfolio is further split into four, roughly equally-sized

portfolios based on sales to further examine the relation between size and tax
rates. Firms in the lowest quartile based on sales (O-25%) were placed in
portfolio # 5. Firms in quartile 25-50x were assigned to portfolio # 4, and
so forth. Portfolio. #2 contains all firms in quartile 75--100% except the
previously classified ‘large’ firms, which are in portfolio # 1. Table 1 reports
the mean tax rates and number of firms included by year from 1947 to 1981.
The total sample is split into five size categories to provide comparability to
the IRS data analyzed in section 3.
In seventeen of the thirty-five years, the mean tax rate in the large
portfolio exceeds the rates in the other four portfolios. (These years are
denoted by one asterisk in table 1). Assuming independence across years, a
binomial test with probability of success of 0.2 rejects the null hypothesis at
126 J.L. Zimmerman, Taxes ana’jlrm size

Table 1
Mean tax rates (taxes paid/operating cashflows) and the number of firms (gtven m
parentheses) in each portfolio by size categories, 1947-1981. Source of data is
COMPUSTAT Firm SIX is measured by sales.

Sue category’
Largest firms have
5 4 3 2 1 highest tax ratesb

1947 0.177 0.192 0.198 0.172 0.175

(107) (111) (109) (68) (44)
1948 0.171 0.176 0.192 0.179 0.169
(116) (117) (115) (79) (37)
1949 0.166 0.157 0.158 0.158 0.151
(123) (124) (123) (86) (39)
**
1950 0.223 0.220 0.235 0.225 0.230
(137) (133) (137) (80) (55)
**
1951 0.259 0.284 0.287 0.245 0.289
(140) (141) (139) (73) (66)
*
1952 0.223 0.261 0.234 0.214 0.245
(150) (140) (142) (91) (53)
**
1953 0.202 0.239 0.231 0.213 0.234
(155) (144) (149) (88) (60)
**
1954 0.178 0.197 0.196 0.185 0.179
(148) (157) (152) (91) (62)
**
1955 0.193 0.208 0.205 0 198 0 222
(167) (164) (168) (106) (61)
*
1956 0.192 0.209 0.201 0.191 0.204
(173) (174) (169) (110) (65)
1957 0.178 0.181 0.191 0.170 0.179
(183) (180) (178) (110) (71)
**
1958 0.169 0.162 0.162 0.165 0.143
(186) (174) (180) (129) (51)
1959 ( 0.187 0.176 0.180 0.181 0.161
(188) (193) (191) (137) (54)
1960 0.153 0.168 0.166 0.165 0.157
(338) (300) (294) (234) (57)
**
1961 0.169 0.168 0.164 0.161 0.165
(346) (341) (329) (268) (61)
**
1962 0.170 0.168 0.157 0.156 0.155
(380) (363) (365) (291) (70)
**
1963 0.162 0.165 0.142 0.153 0.160
(413) (367) (382) (302) (72)
**
1964 0.153 0.153 0.145 0.148 0.151
(408) (390) (397) (327) (62)
**
1965 0.154 0.148 0.146 0.148 0.166
(442) (405) (416) (357) (53)
*
 J.L. Zimmerman, Taxes and firmsize 127

Table 1 (continued)

Size category’
Largest firms have
5 4 3 2 1 highest tax ratesb

1966 0.153 0.147 0.150 0.148 0.153

(452) (435) (440) (386) (49)
*
1967 0.150 0.138 0.136 0.131 0.136
(440) (420) (429) (383) (45)
*+
1968 0.159 0.152 0.143 0.144 0.173
(435) (447) (432) (338) (43)
*
1969 0.153 0.146 0.139 0.137 0.141
(437) (432) (429) (384) (49)
**
1970 0.127 0.128 0.122 0.125 0.131
(408) (386) (392) (340) (50)
*
1971 0.129 0.133 0.126 0.120 0.152
(412) (373) (361) (319) (47)
*
1972 0.139 0.138 0.134 0.120 0.161
(421) (396) (398) (363) (43)
*
1973 0.133 0.133 0.132 0.125 0.177
l
(437) (428) (404) (372) (50)
1974 0.137 0.137 0.136 0.132 0.195
*
(427) (410) (392) (343) (59)
1975 0.124 0.137 0.131 0 118 0.166
l
(424) (405) (389) (344) (53)
1976 0.131 0.140 0.136 0.129 0.169
*
(450) (421) (415) (369) (55)
1977 0.125 0.142 0 139 0.128 0.181
*
(461) (431) (416) (374) (52)
1978 0.133 0.133 0.137 0.130 0.178
*
(465) (436) (427) (384) (51)
1979 0.127 0.128 0.134 0.127 0.158
t
(464) (434) (419) (370) (56)
1980 0.123 0.119 0.118 0.110 0.168
*
(489) (429) (4W (332) (53)
1981 0.133 0.119 0.113 0.108 0.154
*
(372) (382) (342) (313) (54)
Average rank 1947-81 2.8 2.4 3.1 4.1 2.3
Average rank 1970-81 3.0 2.4 3.5 4.8 1.0

‘5 = smallest, 1= largest.
bOne asterisk denotes largest firms have highest mean tax rates, and two astensks
denote largest tirms’ weighted average tax rates exceed the other four portfohos’ mean
and weighted average tax rates.
128 J.L. Zimmerman,Taxes and firmsize

the 0.0001 level. If too many ‘small’ firms (with low tax rates) are included in
the ‘large’ portfolio, then the ‘large’ portfolio will not have the highest tax
rates in all years. To test for this possibility, a weighted average tax rate is
computed for the large portfolio where the weights are the firm’s cashflows
to total portfolio cashflows (not reported). The weighted average tax rates in
the ‘large’ portfolios are higher than either the mean or weighted average tax
rates in the other four portfolios in thirty of the thirty-five years. (These
years, if they are not one of seventeen denoted by one asterisk, are denoted
by two asterisks in table 1.)
The last two rows in table 1 are the average ranks of the mean tax rates
within each year for the entire thirty-live years and for the last twelve years,
respectively. These average ranks indicate that mean tax rates do not increase
monotonically with firm size. In fact, the next to largest size grouping,
portfolio #2, tends to have the lowest mean tax rate and the next to
smallest size grouping, portfolio #4, tends to have the next to highest tax
rate. These findings suggest that average tax rates do not increase strictly
with firm size but rather are better approximated as a step function.
These results are consistent with the political cost hypothesis (i.e., large
firms choose income reducing accounting methods to reduce their political
costs) primarily during the 1970’s. The non-monotonicity of the tax rates also
is consistent with the successful firms-fixed tax shield interpretation discussed
in the introduction. If the ‘large’ portfolio contains a higher proportion of
successful firms than the other four portfolios, then, because tax shields (e.g.,
depreciation and interest) do not expand proportionately with the firm’s
fortunes, the ‘large’ most successful portfolio will have the highest tax rates.

2.3. Industry anabsis

Another explanation for the preceding results is an industry effect. For
example, mining companies which receive large depletion allowances tend to
cluster in certain size categories, thereby distorting the results. Similarly, oil
companies pay foreign taxes for the right to extract natural resources. In the
U.S., these payments are classified as royalties, not taxes. Disaggregating the
results in fig. 1 by industries will partially control for these effects.g
Table 2 reports t-statistics by year and industry. The t-statistics are
calculated as the difference between the mean tax rates in the ‘large’ and
‘other’ portfolios and assume equal variances in the two portfolios.” The

9Because of the well-known problems wth industry definitions and the lack of homogeneity
within industnes, the use of SIC codes does not produce portfolios with entirely homogeneous
firms [see Benston (1975)].
‘OF tests of the sample variances indicate that the null hypothesis of equal vanances IS
rejected slightly more often than by chancem three of the five industnes but not m the entire
sample. In the first column, the null hypothesis is not rejected in any year at 0.01 level In the
remaimng live columns, the null is rejectedfive, two, three, zero and zero tnnes, respectively
 J L. Zimmerman, Taxes and firm wze 129

first column, ‘All Industries’, contain the t-statistics of all firms and provides
significance tests of the difference in means plotted in fig. 1. The null
hypothesis that ‘large’ firms do not have higher tax rates can be rejected at
the 0.05 level only after 1971. The’ remaining columns in table 2 report the t-
statistics on the difference in tax rates between the ‘large’ and ‘other’ firms by
industry. The firms in the ‘large’ portfolio are assigned to one-digit SIC
(Standard Industrial Classification) code industries, as are the ‘other’ firms.
Since using two-digit SIC codes results in very few firms in the ‘large’
portfolios by industry, only one-digit SIC codes are used. Oil refiners (SIC
# 291) were reclassified to SIC # 131 (oil producers) in order to place all oil
companies in one industry. Of the ten one-digit industry codes, five industries
(agriculture, finance, services, health care, and miscellaneous) had no ‘large’
companies and were dropped from the analysis. These four industries contain
roughly 200 of the 1700 firms in 1979.”
From table 2, the earlier finding (large firms have the highest tax rates)
holds at times across all industries, except for trade (industry #5). Within
industries the relation between ‘large’ and ‘other’ firms tax rates is not
stationary over time.
Among extractive resource firms (industry # 1) the large firms had lower
tax rates than smaller firms during the 1950’s. This relationship reversed in
the 1970’s (i.e., the large firms had higher tax rates than smaller firms as
evidenced by the positive t-statistics). Since the early 1970’s, this industry has
the greatest difference in tax rates between ‘large’ and ‘other’ firms. The
largest firms in industry #2 (food, textiles, chemicals, but excluding
refineries) have higher tax rates than smaller firms in thirty of the thirty-five
years and the difference is statistically significant in most years since 1971
(one-sided test, c1=0.05). The relationship between firm size and tax rates is
weaker in the durable manufacturing industry (#3: autos, steel, machinery)
and appears to be declining in importance. This observation is consistent
with the economic decline in the steel and auto industry.
There are roughly one-hundred firms in industry f4 on the
COMPUSTAT industrial files (truck companies, airlines, telephone

“The composition of the ‘large’ portfolio has changed over the penod.

Industry SIC code 1947 1955 1963 1972 1981

Mining, mcluding petroleum 1 13% 20% 19% 26% 37%

Non-durable manufacturing 2 29% 20% 19% 19% 26%
Durable manufacturing 3 39% 51% 40% 37% 22%
Commumcations, shipping, airlines 4 0% 0%
Trade 5 1% 1% ;;
18% 8%
-- - - - -
loo”/, 100% 1W 100% 100%

Most of the ‘large’ firms remain concentrated m the first three mdustnes.
130 J.L. Zimmerman, Taxes and firmsize

Table 2
The r-statistics of difference in mean tax rates (income taxes/operating cashflow) of the largest
fms and all other fms on COMPUSTAT, 1947-1981. Frrm size is measured by sales.

Mining, Communications,
All petroleum, Manufacturing Manufacturmg shipping,
industries construction non-durables durables atrlmes Trade
One-digit SIC code 1 2 3 4 5

1947 - 1.33 - 1.02 -0.01 0.21 -075

1948 -0.71 - 1.09 -0.56 1.23 - 1.03
1949 -0.52 -1.54 0.33 1.20 - 1.05
1950 0.17 - 1.69 -0.14 3.29 - 1.35
1951 0.53 - 1.29 0.77 2.28 - 1.39
1952 -0.71 - 1.53 -0.44 0.94 - 1.04
1953 0.43 - 2.07 1.31 1.68 -1.61
1954 - 1.21 - 1.42 0.25 0.65 -1.64
1955 0.38 -0.67 005 1.94 - 1.54
1956 -0.52 -1.12 -0.16 0.39 - 1.52
1957 -0.57 - 2.02 0.58 0.86 - 1.63
1958 - 1.26 - 1.75 0.44 0.83 - 1.89
1959 -1.10 - 1.53 0.52 045 008 - 1.66
1960 -0.50 -0.61 0.48 1.03 028 - 1.52
1961 -0.04 -1.16 0.39 2.05 1.02 -113
1962 -0.43 -0.91 0.88 1.12 1.21 - 1.41
1963 -0.48 - 1.03 0.67 1.31 1.63 - 1.97
1964 0.56 - 1.50 1.40 1.62 1.67 -0.49
1965 1.17 -1.10 0.13 3.27 154 -0.20
1966 0.23 -0.56 0.35 1.33 1.29 -0.77
1967 -0.19 -0.01 067 0.01 059 -1.26
1968 1.62 -0.10 1.57 2.28 1.05 0.19
1969 -0.16 0.23 0.69 0.58 1.26 -0.64
1970 0.47 1.84 1.39 - 0.49 0.61 -0.52
1971 2.01 2.71 1.76 0.11 -0.10 - 1.01
1972 1.91 3.42 2.34 0.29 -0.26 -0.94
1973 3.50 4.34 3.75 0.55 -0.76 - 1.01
1974 4.40 5.77 2.03 0.49 -070 -0.74
1975 2.87 4.38 0.15 0 16 -1.14 -061
1976 2.59 4.47 0.86 0.55 -0.78 -1.08
1977 3.48 4.54 3 85 0.54 -0.61 -1.11
1978 3.22 3.49 3.63 0.42 0.34 - 0.92
1979 2.20 2.52 2.72 - 1.23 -0.39 -1.04
1980 3.58 4.23 2.36 -0 19 -0.37 -0.81
1981 2.54 4.11 2.28 -0.88 -0.75 - 2.07

companies, and natural gas companies). There are usually three ‘large’ firms
in any given year in this industry (AT&T, Canadian Pacific Ltd., and
General Telephone) and the r-statistics amount to computing the difference
in tax rates between the ‘large’ telephone companies and the airlines,
trucking companies, and gas transmission firms.
The largest trade firms (industry # 5) consistently have lower tax rates
than the smaller firms in their industry. There are approximately nine ‘large’
 J.L. Zimmerman, Taxes and jm me 131

firms in any given year (e.g., K. Mart, J.C. Penney, Safeway, Sears,
Woolworth). While these results are inconsistent with the political cost
hypothesis, they are consistent with other accounting studies that also find
the trade industry inconsistent with the political cost hypothesis [see Watts
and Zimmerman (1978) and Bowen, Noreen and Lacey (1981)].
Returning to SIC # 1, the ‘large’ firms in this industry are the major oil
producers. Up until 1970, oil companies had the highest depletion allowance
(27?/,) of all natural resource companies. Therefore, the ‘large’ firms in this
industry had lower tax rates because the ‘other’ firms in this industry
included non-oil mining firms with lower depletion allowances. The t-
statistics in SIC # 1 were recalculated excluding firms not in the oil and gas
industry. Thirteen of the twenty-two negative t-statistics in the period 1947-
1968 become positive and the largest t-statistic is + 1.42. The t-statistics in
19691981 remain very similar to those in table 2. Therefore, the negative c-
statistics in the period prior to 1970 are due to the (smaller) non-oil mining
firms with lower depletion rates (and higher tax rates) dominating the ‘other’
portfolio in SIC # 1. d
The 1969 Tax Reform Act, which took effect in 1970, reduced the depletion
allowance to 22% and placed limits on the extent to which it applies to
foreign operations. Further changes in the tax code in 1974-1975 repealed
statutory percentage depletion except for very small producers. These
reductions in depletion allowances are one reason for the substantial shift in
the tax rates in this industry. OPEC is another reason for the shift in tax
rates. In the period 1970-1971, the OPEC countries raised their income tax
rates on oil producing companies from 50% to 55%. In 1974 these rates were
raised to 67& [Seymour (19Sl)]. Not all of these higher taxes could be
offset against U.S. taxes via the foreign tax credit because the U.S. limits
foreign tax credits.
Besides affecting oil and gas producers by reducing depletion allowances,
the 1969 Act possibly affected large non-extractive companies. Among its
numerous provisions, this Act (i) limited corporations to a single surtax
exemption and single tax credit for accumulated earnings rather than credits
or deductions for each subsidiary, (ii) reduced the tax advantages to
multinational companies with controlled foreign corporations, and (iii) placed
limits on the deductibility of interest on debt used to finance corporate
acquisitions where such interest exceeds $5 million per year [Fiore and Klein
(1970)]. The effect of each of these provisions is to raise the effective tax rates
of large companies relative to smaller companies. To the extent that the 1969
Act reduced the U.S. tax credit for foreign taxes paid by corporations, this
disproportionately raised the effective tax rates of the ‘large’ oil and
manufacturing tirms because these firms have a higher fraction of foreign
operations than firms in the ‘other’ portfolio. ‘Large’ firms in the trade and
communications and transportation industries were not as affected by the
1969 Act because they have relatively few foreign operations.
132 J.L. Zimmerman, Taxes and firm size

2.4. Sensitivity analyses and specific explanations

Four additional sets of tests were conducted to ensure that the results are
robust to alternative variable definitions and other specific explanations.

2.4.1. Alternative size measures

The results in tables 1 and 2 were replicated using alternative tax rate
measures and an alternative size measure to classify firms into five portfolios.
Tax rates were calculated as the ratios of taxes paid to sales and to pretax
income. These alternative measures of tax rates result in the ‘large’ portfolio
having the highest weighted average tax rates in twenty-one and seventeen of
the thirty-five years, respectively. Using a binomial test and assuming
independent success probabilities of 0.2, both of these results are significant
at the 0.0001 level.
Pretax income was also used to measure size, with even stronger results. In
all thirty-five years, the ‘large’ portfolio has the highest tax rates. However,
sorting firms on pretax income overstates the relationship between size (as
measured by pretax income) and tax rates because of the fixed tax shield
explanation.

2.4.2. The fixed tax shield explanation

As previously discussed, the U.S. tax code induces a positive relationship
between effective tax rates and success (and therefore firm size) because a
firm’s tax shields are fixed in the short run. In a successful year, cashflows,
profits and taxes are higher, while tax shields probably are not
proportionately larger. Assigning firms to portfolios based on size (as in table
1) induces a specific pattern to the average tax rates of the portfolios.
Assume that each firm has an optimum firm size, that these optimum firm
sizes form a continuum, and that yearly variations in sales are random
deviations about the optimum firm size and represent successful/less
successful years. Consider two identical firms (S and U) that have identical
assets and capital structures, the same tax shields and face the same tax laws.
But assume firm S is more successful in generating cashflows. Further assume
S and U are close to one of the size classification boundaries such that firm
S ends up in the larger size portfolio and U in the smaller size portfolio.
Firm S, with less tax shelter per dollar of cashflows, will have a higher tax
rate than the otherwise identical U in the smaller portfolio. The average tax
rates in the two portfolios are the same. The largest firms in S’s portfolio will
tend to be the less successful ones with lower tax rates, and the smaller firms
in U’s portfolio will tend to be the more successful ones with the higher tax
rates. Thus, within all but the largest portfolio, the higher tax rates of the
smaller successful firms will offset the lower tax rates of the larger less
 J.L. Zimmerman, Taxes andjrm size 133

successful firms. The largest size category, which is open ended, contains only
the most successful (higher tax rate) firms.
The fixed tax shield explanation predicts that the mean tax rate will exceed
the weighted average tax rate within a size category. The reason is that the
weighted average will be dominated by the larger less successful firms with
lower tax rates. The mean will average the larger and smaller firms together,
thereby producing a higher average within a size grouping than the weighted
average. The mean tax rate is almost always higher than the weighted
average in each of the four smallest portfolios from 1947-1981 in the total
sample.
Further evidence regarding the fixed tax shield explanation is provided in
table 3. The period 1965-1974 contains three important changes in the
difference in tax rates in (i) the mining/petroleum industry, (ii) the non-
durable manufacturing industry, and (iii) the durable manufacturing industry.
The t-statistics in table 3 are reproduced from table 2. If the fixed tax shield
explanation is correct, then a change in the relative size of ‘large’ versus
‘other’ firms should be associated with a change in the difference in tax rates.
That is, if some firms in an industry become successful and therefore ‘large’
compared to other firms in their industry, they will have higher average tax
rates than ‘other’ firms in their industry (i.e., the ‘large’ firms’ tax rates rise
because their tax shields do not increase as fast as their cashflows). The ratio
of the mean pretax income of the ‘large’ firms to the ‘other’ firms in the
industry is computed for each year, 1965-1974. This ratio measures the

Table 3
Comparison of the t-statistics of differences m mean tax rates (from
table 2) m columns (l), to the ratio of mean pretax Income of ‘large’ and
‘other’ firms, in columns (2), m the three industries dominated by the
‘large’ firms, 1965-1974.

Mining,
Petroleum, Manufacturmg Manufacturing
construction nondurables durables

(1) (2) (1) (2) (1) (2)

1965 -1.10 16.1 0.13 113 3.27 379

1966 -0.56 16.9 0.35 10.4 1.33 32.1
1967 -0.01 18.7 0.67 9.9 0.01 30.7
1968 -0.10 19.1 1.57 10.0 2.28 33.8
1969 0.23 18.5 0.69 9.2 0.58 33.1
1970 1.84 18.3 1.39 8.9 -0.49 27.2
1971 2.71 38.1 1.76 9.1 011 387
1972 3.42 42.3 2.34 10.0 0.29 38 8
1973 4.34 39.7 3.75 9.2 0.55 33.0
1974 5.77 51.4 2.03 9.3 0.49 23.2

“The penod 1975-1981 1s not reported to reduce. the size of the table.
The ratios of mean pretax income m the penod not reported are
comparable to those reported in 1972-1974 for the three industnes
134 J.L. Zimmemwn, Taxes and firmsize

change in relative size within an industry. The fixed tax shield explanation
predicts that the ratio of mean pretax income of the ‘large’ to ‘other’ firms
will change over time in the same direction as the t-statistics of the difference
in mean tax rates change (assuming the variance of the tax rates are
constant).12
In the mining/petroleum industry, the average pretax income of the ‘large’
fums relative to the ‘other’ firms in the industry more than tripled from 1965
to 1974. Over the same period, the differences in tax rates shift from negative
(the ‘large’ firms have lower tax rates than the ‘other’ firms) to significantly
positive. These results are consistent with the fixed tax shield explanation.
However, the results in the non-durable and durable manufacturing
industries are inconsistent with this explanation. In non-durable
manufacturing the difference in mean tax rates becomes significant over the
ten-year period but the profitability of the ‘large’ firms relative to the ‘other’
firms falls slightly. In the durable manufacturing industry, the decline in the
difference in mean tax rates is not associated with a corresponding decline of
relative profitability. Using sales instead of pretax income to estimate the
change in relative size does not alter the preceding conclusions. Thus, the
results in table 3 suggest that the fixed tax shield explanation is not solely
responsible for producing the finding that the ‘large’ firms have higher
average tax rates than smaller firms, but it is a factor.

2.4.3. The ‘good performance/divers@cation’ explanation

Another alternative explanation for the results in tables 1 and 2 is that the
largest firms tend to be the most diversified and are less likely to have
operating losses. If this is the case, then ‘large’ firms have few prior year tax
loss carryforwards and hence have high average tax rates. To test this
possibility, firms were deleted from the sample if their pretax earnings in any
of the last live years prior to the year examined were less than $100,000 and
table 1 was recalculated. This criterion eliminates most tax loss
carryforwards. Similar results as before (not reported) are produced thereby
rejecting the ‘good performance/diversification’ explanation.’ 3
‘*The variances of the tax rates of the three mdustnes m table 3 are stationary over the
period 1965-1974 with the exception of the first industry (oil and gas) whch increased by a
factor of two, primarily in the ‘large’ portfolio.
“Inflatlon is another possible explanation of the results in tables 1 and 2. Inflation Increases
effective tax rates of capital intensive firms if their fixed assets were acquired pnor to the
inflationary penod. If ‘large’ firms have proportionately more older fixed assets than ‘other’
firms, then ‘large’ firms’ effective tax rates wdl be higher due to mflation. This inflation effect
might explain why ‘large’ trade firms do not have higher tax rates than ‘other’ trade firms. Both
groups have relatively few fixed assets and high inventory turnovers. Furthermore, their use of
LIFO tends to minimize the effect of inflation on effective tax rates However, tlus mflatlon
hypothesis per se cannot explam why large od and gas producers tax rates went up so
dramatically relative to other listed ml and gas producers or why ‘large’ durable manufacturers
effective tax rates did not go up relative to ‘other’ durable manufacturers in the 1970’s (see table
2), when this inflation effect should have been most pronounced.
 .I. L. Zimmerman, Taxesand firmsue 135

2.4.4. The foreign tax explanation

The last explanation for the results is foreign taxes. If large firms have
proportionately more foreign operations which are taxed at higher rates than
U.S. operations, large firms will tend to have higher effective tax rates. A
corporations’ worldwide taxes (ignoring state taxes) are generally calculated
as

Worldwide taxes=(U+F)t,+ Ft,-min(Ft,, LIMIT),

where
u =U.S. source income,
F = foreign source income,
&J =U.S. tax rate,
tF =foreign tax rate,
LIMIT = t,,(F + U) x F/(F + U) = t,F.

The last term [i.e., min(Ft,,LzMzT)] represents the extent to which foreign
taxes can be credited against U.S. taxes.
If the foreign tax rate is greater than the U.S. tax rate (tF> t”), then the
firm’s effective worldwide tax rate will be higher than the U.S. tax rate. The
effective rate will increase towards the foreign tax rate (tF) as the fraction of
the firm’s total income represented by foreign income increases. If the U.S.
tax rate is greater than the foreign tax rate (t,> tF), the firm’s effective
worldwide tax rate is the U.S. tax rate and is independent of the fraction of
income from foreign sources. The first case (tF > tu) is probably representative
of most of the companies in the ‘large’ portfolio, especially the oil
companies.r4
By limiting the foreign tax credit (LIMIT), U.S. tax policy increases
effective corporate tax rates. These higher tax rates result from U.S. tax
policy and could be reduced if all foreign taxes are credited against U.S.
taxes. This was the situation between 1918 and 1921. In 1921, a limitation
was placed on the foreign tax credit, thereby increasing the effective tax rates
of firms with extensive foreign operations. These changes were allegedly
motivated by a desire to increase corporate taxes [Owen (1960, pp. 198-
201)].
Limitations on the foreign tax credit discriminate against larger firms more
than smaller firms. Since 1969, COMPUSTAT reports ‘foreign tax expense’

“The relationship between U.S. and foretgn effective tax rates IS examined by companng
foretgn companies quoted on U.S. exchanges to U.S. companies. These foreign compames (e.g.,
Royal Dutch Shell, Umlever, Brittsh Petroleum, Imperial Group, B.A.T. Industnes Ltd., etc.),
which are on COMPUSTAT and are included in the previous tests, have tax rates which exceed
U.S. effective corporate tax rates. Almost all foreign companies are m the ‘huge.’ portfolio and
comprise about 1045% of the total number of companies m the large portfolio. Deletmg these
companies reduces the average tax rates in the ‘large’ portfolio, but does not alter the inferences.
136 J.L. Zimmerman, Taxes andfirm sire

(data item #64). In the ‘large’ portfolio, foreign taxes account for a mean 5%
of the total taxes in 1969 and rise to a mean of 13% by 1981. In the ‘other’
portfolio, foreign taxes account for 1% of total taxes in 1969 and rise to 4%
by 1981. Thus, part of the differential tax rates faced by larger firms are
attributable to the fact that their proportionately greater foreign operations
are being taxed at higher rates than their U.S. operations. The U.S. tax
policy of limiting the amount of foreign taxes that can be credited against
U.S. taxes also contributes to the differential rates. However, foreign taxes
cannot explain all the results. The percent of foreign taxes increases
monotonically with firm size which should cause effective tax rates to
increase monotonically with firm size, but observed effective tax rates do not
increase monotonically.’ 5

2.5. Summary
The roughly fifty largest firms have higher tax rates than other exchange-
listed firms. Tax rates do not increase monotonically with firm size but are
higher only in the largest size category. This result is observed (i) over time,
but is much stronger following the 1969 Tax Reform Act, and (ii) in the three
major industries dominated by large firms. When disaggregated by industry,
the largest firms in each industry have higher tax rates when their profits are
high relative to those of the smaller firms in their industry. These last results
are consistent with the fixed tax shield explanation, but this reason alone
cannot explain all the results. The evidence is also consistent with the
political cost hypothesis (i.e., large firms are most likely to choose income
reducing accounting procedures). However, the data is based on financial
statement data, not actual tax returns. Since accrual accounting procedures
might cause the differences, the next section reports a series of tests using
IRS tax return data.

3. Tests using IRS data

The results in the preceding section are based on estimates of the actual
tax liability using financial statement data. Differences between tax and
“A firm’s worldwide effective tax rate cannot be dtsaggregated into meanmgful U.S. and
foreign components [i.e., the ratro of U.S. (fore& taxes to U.S. (foreign) income]. Calculatmg a
U.S. effective tax rate requires worldwtde income to be apportioned into U.S. and foreign
sources. The results (and inferences) depend on whether the foreign tax credtt 1s included in U.S.
taxes or excluded and there is no conceptual reason for etther treatment Calculating a U.S. tax
rate implicitly assumes that the reported US. portion of worldwrde income IS an unbiased
estimate of U.S. income. But the allocahon of worldwide income into reported U.S. and foreign
incomes is endogenous and depends on the tax nn‘nimixation practices of the firms. A US.
company that manufactures a product in the U.S. and sells it overseas must set a transfer pnce
on the product subject to IRS guidelines. This transfer pnce IS used to allocate the total profit
into a U.S. portion and a foreign portion. Lrke other cost allocations of jomt costs, inferences
cannot be drawn baaed on the allocated numbers.
 J.L. Zzmmerman, Taxes andfirm sue 137

financial accounting can bias the results (e.g., deferred taxes and
consolidation of foreign income). To test for this possibility, this section
reports a series of tests using corporate tax return data as reported by the
IRS. The findings in this section confirm the earlier tests - that large firms
have higher effective tax rates than other firms, the oil industry has the
strongest association between firm size and tax rates, and tax rates do not
increase monotonically with firm size. The magnitudes, time trends and
cross-sectional differences in tax rates are comparable using IRS and
COMPUSTAT data. This suggests that financial statement data yield
unbiased estimates of effective tax rates.

3.1. Data
The IRS annual volumes of Statistics of Income report statistics compiled
from individual corporate tax returns. Selected line items from returns (e.g.,
sales, net income, total taxes) are aggregated according to the firm’s size and
industry and then the totals are reported. Unlike data from individual firms’
financial statements, these volumes do not report in sufficient detail to make
the same calculations or to control the composition of the sample. Nor do
these volumes use the same table formats each year. Also, because the IRS
does not report tax rates by firm, the ratios calculated from the IRS data are
(de facto) weighted averages where the weights are the denominator variables
(e.g., firm cashflows). l6 Thus, larger firms are given larger weights in the
ratios. However, expanding the number of firms in the largest size class has
little effect on the average ratio; the very largest firms, because they are so
large, dominate the results. While all of these problems limit the usefulness of
this data source, some time series and cross-sections can be constructed.
The first step in replicating the COMPUSTAT results is to derive a
comparable measure of the tax liability for the numerator. The measure of
taxes paid from the financial statements includes all income taxes paid to
state and local governments and federal and foreign sources. An
approximately equivalent measure from the U.S. tax return is Income tax,
total - Investment credit + Other taxes paid. (The IRS tax return format is
presented in the appendix.) The sum of the first two terms, by excluding the
foreign tax credit, is an estimate of U.S. and foreign taxes.” For example,
suppose a company has foreign taxes of $20, no ITC, and U.S. taxes before
credits of $50. The U.S. tax due is $30, but the total of U.S. and foreign taxes
%et T and C, denote the taxes pald and cashflows of the zth firm T’he calculated ratios are

The nght-hand side of the equation 1s a welghted average.

“The U.S. tax code also allows other tax credits (e.g, work incentive credits). These other
credits are of such small magnitude that m&ding them does not alter the results.
138 J.L. Zi-n, Taxes and jinn me

are $50. The last term, Other taxes paid, includes state and local taxes,
import tariff duties, business, license and privilege taxes, and income and
profit taxes paid to foreign countries unless claimed as a credit against
income tax. l8
The denominator is Total receipts less Cost of sales and operations. While
this measure approximates Sales less cost of sales from the financial
statements, several differences exist. lg As will be seen, these differences are
empirically unimportant.

3.2. Results

The IRS tables categorize firms by total assets or business receipts. Panel
A of table 4 reports the number of companies in each of the live largest size
categories as defined by the IRS for all corporations from 19561977. A year
was included in table 4 if the IRS Statistics of Income included a table
reporting industry data by firm size (measured by assets or sales) and Cost of
operations. Data for 1977, the latest year, was published in 1982. The
definition of the size categories varies across the years (see footnote a to table
4). Prior to 1965, the IRS disaggregated the data only by total assets. After
1965, firm size was reported using both total assets and business receipts.
The latter measure was used for table 4 because it included fewer companies
in the largest size category. However, in 1975 the IRS combined the largest
two size categories and expanded the smallest size category. These changes
increased the number of companies in size categories one and five in table 4.
Panel B of table 4 reports estimates of total rates of taxation on operating
cashflows. These numbers correspond to those in fig. 1 and table 1. There
were nine years when the IRS reported sufficient data to calculate these tax
rates. Despite the IRS use of receipts in the early years and assets in later
years to measure size and changes in the size category breakpoints, the
largest firms pay more taxes per dollar of operating cashflows than smaller
firms in all nine of the years reported. Assuming independence, this result is
significant at the 0.0001 level using a binomial test. Total rates of taxation
are declining over time as in fig. 1. The numbers in table 1 and panel B of
table 4, are of similar magnitude, except in the largest size category for 1962-
1969, although table 1 reports means and table 4 reports weighted averages.
‘*Foreign taxes will only be taken as a deductIon, rather than as a credit agamst federal taxes,
if the firm does not have any taxes due after other credits (e.g., ITC) [Owen (1960, p. 283)]. By
taking the foreign tax as a deduction, the firm can apply for an immediate refund of the prior
year’s tax. This refund may be more valuable than carrying the excess credit forward
“Management compensation, repalrs, and rent are excluded from the IRS denominator
Interest income, rhvldends, and capital gams are included m the tax returns but excluded m
financial reporting for nonfmanclal corporations. T’he COMPUSTAT data excludes property,
payroll, franchise and other taxes from Income taxes and includes them in cost of goods sold
These taxes are excluded from the IRS Cost ofsales.In addition, prior year tax adjustments and
the effects of carry-forwards are excluded from Income tax. Deprecation IS excluded from costs of
sales by both COMPUSTAT and the IRS.
 J.L. Zimmerman, Taxes and firm size 139

The weighted averages (unreported) corresponding to the means in table 1

are similar to those in panel B.
Unlike the COMPUSTAT results, the last line in panel B, average rank,
indicates that tax rates increase manotonically with firm size. However, these
IRS-based results contain significantly more firms in all size categories. Thus,
the smallest two size categories contain smaller firms than the two smallest
size categories using COMPUSTAT. These smaller firms, if they have lower
tax rates, will impart a monotonic relationship between firm size and effective
tax rates.
Panel C reports the ratio of Other taxes paid (state and local taxes, payroll
taxes, etc.) to operating cashflows. The largest firms report higher Other taxes
paid than smaller firms in all nine years for which data are available.
Assuming independence, this result is significant at the 0.0001 level using a
binomial test. However, the difference in tax rates between the largest and
other size categories is proportionately smaller than that reported in either
panel B or table 1. Like the previous results, Other taxes paid, as a fraction
of operating cashflows, are declining over time, whereas, unlike previous
cases, the tax rates in panel C tend to be monotonic with firm size, as
indicated by the average rank.
So far, only tax rates have been analyzed. However, the availability of
deductions and the extent to which a firm attempts to minimize taxes by
maximizing these deductions affects firm’s rate of taxation. The following
ratio is a measure of relative deductions:”

Cashjlow from operations-Net income

Cashflow from operations *

The numerator is the firm’s total deductions (excluding cost of sales) and
includes advertising, executive compensation, local taxes, etc. (see appendix).
Panel D of table 4 reports the ratio of total deductions to operating
cashflows. The largest firms, those in category 1, reported lower relative
deductions in all thirteen years. A binomial test, assuming independence
across years, produces a p value of 0.0001. Relative deductions are not
declining monotonically with firm size but rather appear to be a step
function. Consistent with the declining tax rates in table 1, panel D portrays
a generally increasing time trend in total deductions.
Table 5 summarizes the three ratios reported in table 4, disaggregated by
industry. Five major industry groupings with firms in the largest five IRS size
categories are reported. These five industries account for between 90-99x of
all the firms reported in table 4. The entries in table 5 are the number of
years that the largest firms have the lowest relative deductions or the highest

“Besides using operating cashflows as a deflator, Total receipts, Net income and Income tax,
total were also used. The inferences are insensitive to deflators.

JAE C
140 J.L. Zimmerman, Taxes and&n Sue

Table 4
Number of firms, total deductions to operating cashflows, state
and local taxes to operatmg cashflows, and federal and other
taxes pad to operatmg cashflows, we&ted average tax rates.

Size category’

5 4 3 2 I
Panel A: Numbers of companies
1956 4774 1773 896 627 453
1957 4958 1811 955 658 471
1958 5322 1898 1001 691 512
1959 5472 2004 1043 736 540
1962 67206 2390 1289 905 638
1965 923 589 216 131 79
1968 1065 749 279 163 123
1969 1172 801 301 161 154
1971 1299 856 358 198 184
1972 1509 989 376 223 209
1973 15578 1822 1130 451 503
1975 18388 2068 1351 512 653
1977 25958 2610 1640 615 790

Panel B: (Income taxes, total- ZTC + Other taxes p&j/

Operatzng cashflows
1962 0.147 0.160 0.165 0.158 0.196
1965 0.162 0.173 0.177 0.175 0.221
1968 0.155 0 163 0.163 0.166 0.203
1969 0.139 0 160 0.162 0.164 0.189
1971 0 129 0.146 0.145 0.135 0.170
1972 0.123 0.118 0.138 0.133 0 162
1973 0.125 0.118 0.138 0.133 0.162
1975 0.119 0114 0 126 0.127 0.167
1977 0.118 0 120 0.127 0.131 0 169
Average rank 4.8 3.6 2.7 2.9 1.0
No. of years the mean tax rate in the largest portfolio exceeds the
mean tax rates m the other four portfohos/No of years=9/9,
p=O.oool.

Panel C: Other taxes paid/Operatmg cashflows

1962 0.076 0.081 0.082 0.076 0.091
1965 0.078 0.083 0.085 0097 0.100
1968 0.080 0.081 0.076 0.093 0.096
1969 0.074 0.086 0.086 0092 0097
1971 0.074 0.088 0.085 0 080 0.094
1972 0.070 0.088 0.084 0.083 0.090
1973 0.068 0.066 0.082 0.078 0.087
1975 0.066 0.066 0 074 p.075 0.086
1977 0.062 0.062 0.070 0.073 0.083
Average rank 44 3.3 3.0 28 1.0
No of years the mean tax rate in the largest portfoho exceeds the
mean tax rates m the other four portfohos/No of years=9/9,
p=O.OOOl.
 J.L. Ztmmerman, Taxes and firm stze 141

Table 4 (continued)

Size categorf

5 4 3 2 1

Panel D. Total deductlons/Operatmg cashflows

1956 0.753 0.748 0718 0 729 0.656
1957 0.771 0.782 0.762 0.751 0.698
1958 0.763 0.759 0.743 0.743 0.719
1959 0.801 0.790 0 767 0771 0 757
1962 0860 0.833 0 823 0804 0771
1965 0.788 0.777 0.785 0791 0.725
1968 0.812 0.791 0.798 0.839 0.773
1969 0.856 0.826 0.838 0.846 0811
1971 0881 0.867 0 862 0 871 0.835
1972 0.859 0 863 0 864 0.876 0.828
1973 0.855 0.863 0 870 0.864 0.819
1975 0.877 0 879 0.884 0881 0 810
1977 0 856 0 857 0.855 0857 0.788
Average rank 40 33 3.0 3.7 1.0
No. of years the mean tax rate m the largest portfoho exceeds the
mean tax rates in the other four portfohos/No. of years= 13/13,
p=O.OOOl.

‘The followmg SW categones were used.

1956-1962 1965-1972 1973-1977

Size Total Busrness Busmess
category assets receipts recefpts

1 (smallest) $250M SIB %5OOM

2 SlOOM-250M SSOOM-1B $250M-500M
3 %50M-1OOM %250M-500M SlOOM-250M
4 $25M-50M IFlOOM-250M %50M-1OOM
5 (largest) %lOM-25M* S50M-1OOM SlOM-50M

Note. In 1962 only this size category was expanded to SlM-25M

taxes. For example, within the manufacturing industry, the largest firms have
the lowest deductions to cashflows in ten of the thirteen years (p value of
0.0001 using a binomial test). Alternatively, the largest manufacturing firms
have the highest Other taxes paid in four of the nine years (p value of 0.09).
Examining the rows of table 5, the political cost hypothesis is supported
by all the industries except wholesale and retail trade, as was the case in
table 2. Pooling the number of times the three ratios are in the correct
direction as predicted by the political cost hypothesis and then summing
across the five industries gives the value reported in the rightmost column of
the last row. Out of 138 cases, this hypothesis gives the correct prediction
sixty-five times. While the three ratios are not independent, if independence is
assumed, a binomial test rejects the null hypothesis at a p value of 0.0001.
142 J.L. Zimmerman, Taxes ana’firm size

Table 5
Number of years that the largest firms have the smallest total deductions to cashflows and the
highest other taxes paid and total taxes to cashflows, and the associated p values, 1962-1977.

Other taxes
Total deductions patd” Total taxesb
Operating Operatmg Operatmg
cashflows cashflows cashflows Total

Manufacturmg 10/13 419 519 19/31

0.0001 0.09 0.02 0.001
Mining/petroleum 919 114 414 14117
0.0001 0.59 0.002 O.OOQl
Transportatton 5112 l/8 4P lo/28
and utilities 0.07 0.50 006 0.04
Wholesale and 4113 019 019 4131
retail trade 0.25 - - 0.23
Fmance, Insurance, 4113 519 919 18/31
and real estate 0.25 0.02 Ooool 0.001

Total 32160 1l/39 22139 651138

p value 0.0001 0.14 0.0001 O.@OOl

“Other taxes pard constttute state and local taxes, payroll taxes, duties and tartffs, etc.
bTotal taxes are federal and foretgn taxes plus other taxes pard.

The results in table 5 are very similar to those for the comparable period
in table 2. Both COMPUSTAT and the IRS data report the largest
statistically significant differences in tax rates among ‘large’ and ‘other’ firms
in the mining/petroleum and manufacturing industries. The utilities have the
third largest significance level in both tables. But the samples are not
comparable because the COMPUSTAT industrial files do not contain public
utilities. In table 5, the finance industry has significant differences whereas in
the COMPUSTAT data, no ‘large’ lirms were in this industry, hence no tests
were conducted. Since the results in tables 4 and 5 are very similar to the
findings from the COMPUSTAT data, this suggests that accrual accounting
procedures are not distorting the results and that financial statement data
can be used to estimate taxes paid and effective tax rates.

3.3. Additional evidence

Two additional sets of evidence using IRS data also support the earlier
results. First, effective tax rates were calculated using Net income (or deficit),
a pretax measure, in the denommator. While this denominator is widely used
in studies constructing effective tax rates [Weiss (1979)], it does not capture
 J.L. Zimmerman, Taxes andfirm sue 143

differential deductions that can cause tax rates on cashflows to differ across
firms. For example, suppose one firm has larger sales ($400) and total
deductions ($350) than another firm (sales of $200 and deductions of $150).
Both firms nevertheless report the same pretax income (%50), pay the same
taxes ($25) and report the same effective tax rates (50%) on income, but not
on cashflows.
The ratio of Income Tax (before credits) minus Znvestment Credit to Net
Zncome (or deJicit) was calculated for the period 1955-1975. Some years are
missing because the IRS did not publish the corresponding table. The IRS
reports data disaggregated by the size of net income. The five largest net
income groupings were examined, thereby excluding companies reporting
losses. These live groups contain between 1100 and 2200 companies.
Weighted average tax rates were calculated for each of the tive groups (not
reported). The group with the largest companies has the highest tax rates in
fourteen of the nineteen years and in every year since 1959 except 1962.
Based on a binomial test and assuming independence across years, this result
is significant at the 0.0001 level. The threshold effect also is observed.
However, because net income is used to measure size these results can be
explained by the fixed tax shield explanation discussed in section 2.
The second set of evidence is from a Treasury study of corporate tax rates
[U.S. Treasury (1978)]. Both the COMPUSTAT and IRS data have not been
adjusted for such factors as tax loss carryforwards or excess preferential
deductions. Although these adjustments are not feasible due to unavailability
of data, they might be biasing the results. A 1978 U.S. Treasury study of
1972 corporate tax rates provides evidence of the effects of omitting these
adjustments. The Treasury study, based on tax returns, calculates the ratio
previously described [income taxes less ITC to net income (or deficit)]. The
numerator and denominator are adjusted to correct for timing differences
and differential deductions. 21 Firms are then grouped by assets and tax rates
are calculated for each group (not reported). The 159 largest firms (assets
over $1 billion) have the highest effective tax rates, and the four smallest size
categories have roughly equal tax rates; again, the tax rate is not monotonic
across categories. The tax rates reported in the Treasury study are
comparable to those calculated using the IRS Statistics of Income. This
suggests that the Treasury’s adjustments have a negligible effect and do not
alter previous conclusions.
The Treasury study also reports effective tax rates by firm size and
*‘The Treasury study makes the followmg adjustments: (i) financial corporattons, subchapter
S and DISC compames are ehmmated, (II) compames reporting losses are ehmmated (because
the numerator does not m&de refunds - negattve taxes - whereas the denominator includes
the losses), (m) foretgn taxes are mcluded m the numerator as are the offsettmg foreign tax
credits, (IV) the tax benefits of loss carryforwards are added back to the numerator and
denommator, and (v) the excess of preferenttal deducttons (depletton, Interest on state and local
bonds, 5-year special amortization prtvtleges) over thetr normal allowances are added back to
the denominator.
144 J.L. Zimmerman,Taxes andfirm me

industry. The oil and gas industry shows the strongest relationship between
firm size and worldwide tax rates. The other four industries examined
generally report that the largest firms have the highest tax rates, except for
public utilities (which were not included in the COMPUSTAT tests). The
only ‘anomaly’ is the trade industry. Both tables 2 and 5 fail to find the
largest trade firms have higher tax rates than other trade firms. The Treasury
study finds just the opposite for 1972.

3.4. Summary
The findings in this section, based on IRS tax returns, confirm the previous
results from individual firms’ financial statements. All corporate returns are
analyzed, thereby avoiding a COMPUSTAT survivorship bias. Various tax
rates are computed (state, local and payroll taxes to cashflows, deductions to
cashflows, total taxes paid to cashflows, and taxes to pretax income). Also,
alternative measures of firm size are used (assets, receipts, and pretax
income). Across these different procedures, the three previous findings are
observed: (i) large firms pay proportionately more taxes than small firms, (ii)
when comparing the largest 2000 firms, tax rates are only different for
roughly the largest fifty firms (i.e., a threshold effect), and (iii) large firms
have higher tax rates within industries, with the petroleum and
manufacturing industries being the most pronounced and trade showing no
differential tax effects (except in the Treasury study).

4. Conclusions

4.1. Summary and findings

Prior accounting studies tested the political cost hypothesis that large
firms are more likely than smaller firms to choose accounting procedures
that reduce reported income. The results of these tests are consistent with the
hypothesis. This paper argues that effective corporate tax rates are partial
measures of the firm’s political costs and hence provide evidence on the
association between firm size and political costs. Tax rates measure a firm’s
political costs for two non-mutually exclusive reasons: (i) Corporate taxes are
a direct means of transferring corporate wealth and comprise one component
of the firm’s political costs. And (ii), if successful firms are subjected to
greater political scrutiny than less successful firms, then because interest and
depreciation tax shields tend to be fixed in the short run, corporate tax rates
are positively associated with firms’ success and hence are proxies for
government scrutiny.
This paper finds that corporate tax rates are associated with firm size
thereby supporting the previous use of lirm size as a proxy for a firm’s
political costs. The roughly fifty largest firms have higher tax rates than other
 J.L. Zimmerman, Taxes and firm sue 145

firms. The association between size and tax rates is strongest in the oil
industry following the 1969 Tax Act and weaker, but statistically significant
associations are observed in manufacturing throughout the period 195&1981.
Moreover, tax rates do not increase monotonically with firm size. These
results are robust to (i) alternative measures of tax rates, (ii) alternative
sources of data, and (iii) different measures of firm size.
Three possible reasons for these results are examined: (i) fixed tax shields,
(ii) elimination of the oil depletion allowance, and (iii) foreign taxes. While
each of these reasons can explain some of the results, no single reason
explains all the results. For example, all three reasons are consistent with the
results in the oil industry, but the fixed tax shields and oil depletion
allowance explanations do not explain the findings in the manufacturing
industry. Data are not available to test the foreign tax explanation in the
manufacturing industry prior to 1970.

4.2. Relationship to previous studies

This paper’s findings are similar to those of other accounting studies in
four ways. First, the association between firm size and choice of income
reducing accounting procedures is strongest in the oil industry and is also
observed among manufacturing firms. In this study, the oil industry has the
strongest association between tax rates and firm size and the manufacturing
industry a weaker association. Second, large firms’ effective tax rates are
higher than smaller firms primarily in the 1970’s. This is also the period
examined by the accounting studies. The only study of choice of accounting
procedures which involves firms pre-1970 is Gagnon (1971), who failed to
find a size effect. Third, results from the trade industry are inconsistent with
the political cost hypothesis in the accounting studies and in this study.
Fourth, the accounting studies tend to find firm size a discriminating variable
only among the largest firms [Watts and Zimmerman (1978) and Zmijewski
and Hagerman (1981)]. This paper finds that effective tax rates do not
increase monotonically with firm size but rather are only larger among the
largest firms.

4.3. Unresolved issues

While this paper provides results consistent with the political cost
hypothesis and other accounting studies, it raises four new questions:
(a) The three possible reasons for these results (i.e., fixed tax shields,
depletion allowances, and foreign taxes) individually and collectively are
unable to explain all the results. Are there other tax mechanisms that explain
the results?
146 J.L. Zimmerman, Taxes and firm size

(b) The trade industry produces conflicting results. Both financial

statement data and IRS data produce evidence on the trade industry
inconsistent with the political cost hypothesis. However, the U.S. Treasury
study finds just the opposite.
(c) If the limitations on the foreign tax credit were eliminated, would large
firms still have higher tax rates? Answering this question is difficult due to
the identification problem. Deleting firms with foreign operations eliminates
almost all large firms, and it is virtually impossible to make adjustments to
companies’ reported numbers to eliminate their foreign operations. The
analysis can be limited to industries without foreign operations (e.g., public
utilities), but without a theory as to why these firms do not have foreign
operations, interpretation of the results is difficult.
(d) Taxes are not a complete measure of the total costs incurred by the
firm due to the political process. The finding that tax rates vary by firm size
is neither a necessary nor sufficient condition for political costs to vary with
firm size. If the non-tax component of political costs vary in opposite sign
and in greater magnitude than taxes, then larger firms do not incur
proportionately higher costs, even though they face higher rates of taxation.
This study provides estimates of the magnitudes of the benefits (e.g., from the
political process or due to economies of scale) that the largest firms must
receive in order to offset the observed higher rates of taxation. For example,
in 1981, each of the fifty-four largest firms had to be receiving benefits either
via the political system or due to economic rents of $175 million per year to
offset the additional taxes paid above the other size groups. If the twenty
large oil companies are deleted, the average per firm excess taxation is $38
million. This study raises the question of how large firms can compete and
survive and still pay these proportionately higher taxes.

Appendix

Internal revenue service income statement format22

x if item
is reported
in 1975
Statistics
of Income
Total receipts X

Business receipts X
Interest on government obligations
U.S. obligations
State and local obligations
22Source IRS, Sourcebook of Statistics of Income, 1961.
 J.L. Zimmerman, Taxes and firm size 141

Other interest
Rents
Royalties
Net S-T capital gain less L-T loss
Net L-T capital gain less S-T loss
Net gain, non-capital assets
Dividends, domestic corporations
Dividends, foreign corporations
Other receipts
Total deductions
Cost of sales and operations X

Compensation of officers
Repairs
Bad debts
Rent paid on business property
Other taxes paid X

Interest paid X

Contributions or gifts
Amortization
Depreciation X

Depletion
Advertising
Pension, profit sharing, annuity plans X

Other employee benefit plans X

Net loss, non-capital assets

Other deductions
Total receipts less deductions
Constr. tax inc. from related foreign corp.23
Net income (or deficit)
Statutory special deductions
Net operating loss carryforward
Dividends received deduction
Deduction for dividend paid on public utility stock
Western hemisphere trade deduction
Income subject to tax X
Income tax (before credits), total X
10% surcharge (1968-1970)
Tax recom. prior year investment credit
Foreign tax credit X
Investment credit X
Net income after tax

23Since the 1962 Revenue Act, certain income from related foreign corporations only
constructively received IS included in net income.

JAE- D
148 J.L. Zmunerman, Taxes and firmsize

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