10.1016@S0278 42549600055 5

NORIH- B(MJAND
Determinants of the Variability

in Corporate Effective Tax Rates:
Evidence from Longitudinal Data
Sanjay Gupta and Kaye Newberry
Based on micro-level longitudinal data spanning the Tax Reform Act of 1986
(TRA86), our study's results suggest that ETRs are not associated with firm size
when the relation is examined over time with firms having longer histories.
However, results show that ETRs are associated with a firm's capital structure,
asset mix, and performance, and that some of these associations continued after
TRA86. These findings call into question the tendency of interest groups to focus
simply on firm size to draw inferences about equity and neutrality of the tax
system. The results also cast doubt on whether TRA86 levelled the playing field.
1997 Elsevier Science Inc.
1. Introduction
Average effective tax rates (ETRs) have long been used by policy makers
and interest groups in tax reform debates, especially those related to
corporate tax provisions. ETRs (usually measured as some ratio of taxes
paid to income) are attractive in these debates because they conveniently
summarize in one statistic the cumulative effect of various tax incentives. 1
Evidence that corporate ETRs vary across firms and over time has been
Address correspondence to: Sanjay G u p t a , School of Accountancy, College of Business, Arizona

State University, T e m p e , Arizona 85287-3606, USA.
1 T h e r e exist many different kinds of effective tax rates in the literature. See Fullerton (1984) for
a taxonomy of these different definitions, and Callihan (1994) for a recent survey of the literature
on ETRs. Most commonly, distinctions are m a d e b e t w e e n average and marginal ETRs. The
appropriateness of each m e a s u r e depends upon the research question. A v e r a g e E T R s are appropri-
ate to m e a s u r e the distribution of tax burdens across firms or industries, whereas marginal E T R s
are appropriate to analyze the incentives for new investments. In this study, we use the t e r m E T R s
to m e a n average, not marginal, effective tax rates.
Journal of Accounting and Public Policy, 16, 1-34 (1997)

1997 Elsevier Science Inc. 0278-4254/97/$17.00
655 A v e n u e of the Americas, New York, NY 10010 PII S0278-4254(96)00055 -5
2 S. Gupta and K. Newberry
used to suggest that the tax system is inequitable, and as a justification for
instituting reform. A series of reports published by the Citizens for Tax
Justice (CTJ 1984, 1985, 1986) provide a particularly vivid example of the
role played by ETRs in recent tax policy debates. Based on ETR calcula-
tions, the CTJ claimed that the largest United States (U.S.) corporations
were not paying their fair share of taxes. The CTJ reports are widely
believed to have influenced many of the sweeping changes in the Tax
Reform Act of 1986 (TRA86) which led to the largest corporate tax
increase in U.S. history--S120 billion over five years (Spooner 1986, p. 293;
Birnbaum and Murray 1987, pp. 11-13). The increase in corporate tax
burdens was achieved primarily by reducing or eliminating certain tax
preferences with the explicit objective of levelling the playing field across
firms.
Given the focus of the tax policy debates, several studies have attempted
to examine whether ETRs are systematically related to firm size. The
results have been mixed; whereas some studies indeed have observed a
negative association between ETRs and firm size (e.g., Siegfried 1972, pp.
249-254; Porcano 1986 p. 23), others have observed a positive relation
(e.g., Zimmerman 1983, pp. 126-127) and still others, no association (e.g.,
Stickney and McGee 1982, pp. 142-143; Shevlin and Porter 1992, p. 76).
However, a fundamental limitation of most of these studies is that they
tend to have examined the ETR-firm size relation in a univariate frame-
work, which potentially creates a correlated omitted variables problem.
This problem stems from variations in ETRs arising from differences in
firms' capital structures and asset mixes, because different financing and
investment choices face different tax treatments, and these choices are
likely correlated with firm size. In addition, there is a potential construct
validity issue with these studies because firm size is well known to proxy for
many different constructs, especially industry membership (Ball and Foster
1982, pp. 182-184). Finally, recent studies have cautioned against attribut-
ing changes in ETRs solely to changes in tax laws without controlling for
changes in firms' incomes (Wilkie 1988, p. 87; GAO 1990, p. 3; Shevlin and
Porter 1992, p. 65). None of the prior ETR studies have addressed all of
these issues together.
Our study provides new evidence on the determinants of variability in
corporate ETRs in a multivariate framework, using micro-level longitudi-
nal data. Specifically, we examined the association between ETRs, firm
size, and variables proxying for firms' capital structures and asset mixes,
while controlling for firms' profitability. In addition, we controlled for
firms' industry membership because these firm-specific characteristics might
differ systematically by industry. Finally, we conducted formal tests to
examine the impact of TRA86 on these associations and whether ETRs
are associated with these firm-specific characteristics since tax reform.
Determinants of Corporate Effective Tax Rates 3
From a research design perspective, our study differs from most prior
studies by examining the determinants of ETR variability with longitudinal
(panel) data which follow the same finn over time. 2 By including a
separate intercept for each finn, fixed-effects regression models, estimated
with panel data, offer the advantage of controlling for unobserved or
unmeasurable variables if these variables do not vary much over time.
Thus, for reasons discussed later, the impact of other variables not
explicitly included in the model (such as the extent of foreign involvement,
ownership structure, compensation policies, and corporate culture) is po-
tentially accounted for in this study.
The sample consists of balanced panels of firms for the periods
1982-1985 and 1987-1990, which span TRA86 and allowed us to examine
the determinants of ETR variability over two tax regimes. 3 Multiple
regression results are presented for fixed-effects models that exploit the
advantages of panel data. Although our focus was not on developing and
testing the accuracy with which the magnitude of ETRs is measured, a
matter of considerable controversy in the literature (e.g., Omer et al. 1991;
Shevlin and Porter 1992, pp. 63-64; Wilkie and Limberg 1993, pp. 83-85),
we tested the robustness of our results to alternate ETR measures.
The empirical results make several contributions to the policy debate on
corporate tax burdens. First, the results suggest that ETRs generally are
not associated with firm size, when the relation is examined over time with
firms which have longer histories. This finding is contrary to the claims in
the popular press but consistent with some of the recent research. Second,
the results show that ETRs are systematically related to a finn's capital
structure and asset mix, which calls into question the tendency of interest
groups to focus simply on firm size to draw inferences about equity within
the tax system. In addition, the results indicate the importance of control-
ling for changes in a finn's income in a model examining ETR variability.
Finally, the results reveal that, while TRA86 had a significant impact on
2 The early studies (e.g., Siegfried 1972) used industry-level d a t a which h a d at least two problems:
first, firms' business typically spans m a n y different industry groups; a n d second, a g g r e g a t e d industry
d a t a obscure individual firms' differences (Stickney a n d M c G e e 1982, p. 127). The studies using
firm-level d a t a have examined E T R variations using either cross-sectional (e.g., Stickney a n d
M c G e e 1982; P o r c a n o 1986) or time-series data (e.g., Z i m m e r m a n 1983). A l t h o u g h Shevlin a n d
P o r t e r (1992) used panel data, their regression models did not fully exploit panel d a t a properties,
a n d they e x a m i n e d only firm size a n d income effects.
3 Panels are b a l a n c e d in t h a t firms were included only if they h a d requisite d a t a for the entire
period of the panel. Two sets o f b a l a n c e d panels were u s e d in the study. T h e first set was
c o n s t r u c t e d such t h a t the panels were b a l a n c e d for each time period (1982-1985 a n d 1987 1990),
but the s a m e firms w e r e not r e q u i r e d to be in b o t h panels. K e e p i n g the panels confined to a short
period has two a d v a n t a g e s - - t h e c h a n c e s of i n t r o d u c i n g survivorship bias are r e d u c e d a n d the
control for firm-specific, time-invariate, u n o b s e r v e d variables is likely stronger. T h e d i s a d v a n t a g e is
t h a t formal tests of differences b e t w e e n the pre- a n d p o s t - T R A 8 6 tax regimes is not possible as
these panels do not c o n t a i n the s a m e firms. H e n c e , we also c o n s t r u c t e d a s e c o n d set of b a l a n c e d
panels such t h a t the s a m e firms w e r e p r e s e n t in b o t h panels, i.e., only firms with all eight years of
d a t a were included.
these relations, ETRs have continued to be associated with several firm-

specific characteristics even after tax reform. This finding casts doubt on
the claim that TRA86 levelled the playing field among firms, at least with
respect to these characteristics.
The rest of the paper is organized as follows. In Section 2, we present
the theoretical arguments and results of previous research which lead to
the development of hypotheses tested in our study. In Section 3, we discuss
our research methods, including the sample selection procedures, variable
definitions, and estimation procedures. In Section 4, we present our
results. Lastly, in Section 5, we conclude with policy implications of the
results and potential limitations of the study.
2. Prior Research and Hypotheses Development

2.1 ETRs and Firm Size
The focus on the relation between E T R s and firm size in the literature has
arisen primarily because of two opposing viewpoints. Under the political
cost theory, the higher visibility of larger and more successful firms causes
them to be victims of greater regulatory actions and wealth transfers
(Watts and Zimmerman 1986, p. 235). Because taxes are one element of
the total political costs borne by firms, this theory suggests that larger firms
face higher ETRs (Zimmerman 1983, p. 119). Alternatively, it can be
argued that larger firms have greater resources to influence the political
process in their favor, engage in tax planning, and organize their activities
to achieve optimal tax savings (Siegfried 1972, pp. 32-36). Under this
political power or clout theory, larger firms are expected to face lower
ETRs.
The claim in the CTJ studies (e.g., CTJ 1986, pp. 1-2) that larger firms
have low ETRs, especially prior to TRA86, is based on data for a subset of
the Fortune 500 firms and observations such as:
Out of the 250 corporations surveyed in this report, 130--or more than half
the total--were able to pay absolutely nothing in federal income taxes, or
receive outright tax rebates, in at least one of the five years from 1981 to 1985.
(CTJ 1986, p. 2).
Based on an increase in ETRs during the post-TRA86 period for a similar

sample of very large firms, the CTJ (1988) concluded that "tax reform is
working" (1988, p. 9) in that is has "created a more level playing field for
all businesses" (1988, p. 4). The principle limitation of the CTJ studies is
that the methodology was mostly ad h o c - - t h e sample was not representa-
tive, there was no control sample of smaller firms, and there were no
statistical tests of significance. 4
Although other studies which have examined the ETR-firm size relation
more systematically do not suffer from some of the methodological limita-
tions inherent in the CTJ studies, they have not produced consistent
results. Using time-series data from 1947 to 1981 for all firms on Compus-
tat, Zimmerman (1983, pp. 126-131) found evidence of a positive though
non-monotonic relation between ETRs and firm size. However, this rela-
tion varied by industry (the oil and gas industry exhibited the strongest
relation, whereas the trade industry had a negative relation) and time
period (the relation was statistically significant at the .05 level, two-tailed
tests only, after 1971) (Zimmerman 1983, pp. 126-131).
In contrast, Siegfried (1972, pp. 239-254) and Porcano (1986, pp. 23-24)
observed an inverse relation between ETRs and firm size, and Stickney
and McGee (1982, pp. 142-143) found that size was not a significant factor
in explaining variation in ETRs. All of these studies used different empiri-
cal procedures, including sample selection, time periods, data aggregation
methods, ETR definitions, and firm-size proxies. Wilkie and Limberg
(1990) attempted a reconciliation of Zimmerman's (1983) and Porcano's
(1986) results, and found (1990, p. 91) that the different results were
largely due to differences in the empirical procedures used. Kern and
Morris (1992) extended Wilkie and Limberg's (1990) reconciliation to
three years beyond TRA86 (1987-1989). They (1992, pp. 82, 95) concluded
that Zimmerman's results are more robust to different empirical proce-
dures than Porcano's (1986) results, and that significant differences in
ETRs between large and small firms may no longer exist in the post-TRA86
period.
Shevlin and Porter (1992) conducted an in-depth reexamination of CTJ's
(1988) evidence on TRA86's impact on ETRs of large firms by controlling
for changes in firms' incomes and comparing CTJ's sample from the
Fortune 500 with a sample of relatively small firms matched on industry.
Consistent with CTJ, they (1992, pp. 70-72) found that ETRs of large firms
increased after TRA86. However, their (1992, p. 76) control sample analy-
sis indicated that ETRs of both small and large firms increased from pre-
to post-TRA86, and that differences in ETRs of the two groups were not
4 Studies similar to CTJ's also have been conducted by the U.S. Congress, Joint Committee on
Taxation (JCT 1983, 1984), which arc known as the Pease-Dorgan studies after their sponsors
Congressmen Don J. Pease and Byron L. Dorgan, and the U.S. General Accounting Office (GAG
1990, 1992). All of these studies share some similarities, especially in that their sample firms
overlap. As with CTJ (1988), the G A O studies (1990, 1992) found that ETRs increased in the
post-TRA86 period. However, they r e c o m m e n d e d examining more than one year's data and, more
importantly, evaluating how taxes change when additional income is earned. The income control
issue and results of Shevlin and Porter's (1992, pp. 70-76) study that empirically implemented this
control are discussed later.
statistically significant either before or after TRA86. Thus, Shevlin and

Porter (1992, p. 77) concluded that TRA86 did not differentially impact
large versus small firms and, hence, CTJ's assertion about TRA 86 creating
a more level playing field "does not extend to different size firms (as the
playing field already appeared level)."
Finally, Manzon and Smith (1994) recently examined whether changes in
ETRs over three tax regimes (the pre-Economic Recovery Tax Act of 1981
(ERTA), and pre- and post-TRA86) were associated with firm size for a
large sample of firms on Compustat. In regression models, which also
controlled for capital intensity, they (1994, p. 358) found that changes in
worldwide ETRs over the three tax regimes were not related to firm size,
which is similar to Shevlin and Porter's (1992, p. 76) findings and Stickney
and McGee's (1982, pp. 142-143) early results.
2.2 ETRs and Firms' Operations and Financing

and Investment Decisions
Except for Stickney and McGee (1982), Shevlin and Porter (1992), and
Manzon and Smith (1994), all of the above studies have focused on the
univariate relation between ETRs and firm size. This approach does not
consider the effect that other firm characteristics have on ETRs. In our
study, we also have examined the effect of firms' operations and financing
and investment decisions on their ETRs.
There are at least two ways in which firms' operations can impact ETRs.
First, Wilkie (1988, pp. 76-77) demonstrated that ETRs are a function of
the ratio of tax preferences to book income, where tax preferences are
items which cause taxable income to be different from book income. To
the extent tax preferences are not proportionally related to book income,
ETRs can change simply because of changes in book income (Wilkie 1988,
p. 77). Thus, before one can infer whether firms with a particular charac-
teristic (such as large size) have benefitted from a greater share of tax
preferences (as claimed by the CTJ), it is necessary to control for changes
in income. Second, Wang (1991, pp. 167-168) demonstrated with path
analysis that net operating losses (NOLs) not only affect ETRs, but that
NOLs are correlated with firm size. Specifically, NOLs may induce a
positive ETR-firm size relation because larger firms are less likely to have
NOLs, in part, due to their greater diversification (Zimmerman 1983, p.
134). This relation suggests the need to control for a firm's NOL status. 5
5 For this and other reasons, the typical response in prior research has been to omit N O L firms
from the sample on the claim that their inclusion might bias the results. However, an anonymous
reviewer c o n t e n d e d that N O L firms should be included in any E T R study because it is the tax rules
which force these firms to postpone utilizing their NOLs. Although the results presented in our
p a p e r are based on the conventional approach of omitting N O L firms, we conducted sensitivity
analysis (discussed later) including these firms.
Firms' financing and investment decisions also are likely to impact their
ETRs because the tax code accords differential treatment to the capital
structure and asset mix decisions of firms. Consider, for example, whether
a firm relies more heavily on debt or equity to finance its operations. Given
that interest expenses are deductible for tax purposes, whereas dividends
are not, firms with higher leverage would have lower ETRs. Alternatively,
a positive relation between ETRs and leverage is possible if firms with high
marginal tax rates are more likely to use debt financing. Similarly, a firm's
asset mix could impact its ETR given the tax benefits historically provided
for capital investment. For example, the tax code typically allows taxpayers
to write-off the cost of tangible depreciable assets over periods much
shorter than their economic lives. Thus, firms which are more capital-in-
tensive would be expected to have lower ETRs. 6
Indeed, Stickney and McGee (1982, pp. 142-143) have provided evi-
dence of an association between a firm's ETR and its capital structure and
asset mix. Using cluster analysis on cross-sectional data from financial
statements for 1978 and 1980, they found that a firm's leverage and capital
intensity has a significant negative relation with ETRs. 7Although Stickney
and McGee (1982, p. 127) overcame the fundamental limitation of univari-
ate studies by examining the impact of multiple firm-specific characteristics
on ETRs, their analysis is limited in several ways. First, their evidence is
dated and pertains to only one tax regime (the period prior to ERTA);
second, they did not control for the impact of firms' operations; and third,
their ETR definition leads to certain interpretation problems regarding
their conclusions.8
As with firm size, there is considerable interest in examining whether
TRA86 impacted the relation between ETRs and a firm's financing and
investment behavior. The interest stems from TRA86's objective to level
6 In their classic paper, D e A n g e l o a n d Masulis (1980, p. 21) suggested a negative relation between
capital intensity a n d leverage, as they p r e d i c t e d t h a t firms will substitute b e t w e e n investment-re-
lated tax shields (e.g., d e p r e c i a t i o n a n d investment tax credits) a n d debt tax shields. Empirically,
studies have f o u n d evidence of this substitution effect, but only for those firms with a substantial
probability of losing their tax shields (Dhaliwal et al. 1992, pp. 13-15; Trezevant 1992, pp.
1565-1566); otherwise, the evidence has t e n d e d to s u p p o r t a positive relation between investment-
related tax shields a n d debt tax shields (e.g., Bradley et al. 1984, p. 873; Dhaliwal et al. 1992, pp.
12-15). As m e n t i o n e d earlier, our sample does not include firms with N O L s , thereby r e d u c i n g the
possibility of a substitution effect in o u r data.
7Stickney a n d M c G e e (1982, pp. 1 3 2 - 1 4 2 ) also included in their model the extent of n a t u r a l
resource involvement a n d the extent o f foreign operations. However, the results for n a t u r a l
r e s o u r c e involvement were a m b i g u o u s , a n d the results for the extent of foreign o p e r a t i o n s were not
significant.
8 Specifically, Stickney a n d M c G e e (1982, p. 130) m e a s u r e d E T R as income taxes payable divided
by pretax b o o k income minus d e f e r r e d tax expenses grossed up by the statutory tax rate (the
d e f e r r e d tax adjustment eliminated the effect of timing differences). B e r n a r d (1984, p. 75) n o t e d
t h a t Stickney a n d M c G e e could not s u p p o r t their conclusion t h a t d e d u c t i o n s for leverage a n d
a c c e l e r a t e d tax d e p r e c i a t i o n lead to lower E T R s , b e c a u s e these tax p r e f e r e n c e s r e d u c e d b o t h the
n u m e r a t o r a n d the d e n o m i n a t o r of their E T R m e a s u r e (i.e, there is no impact on the E T R ratio).
To o v e r c o m e this limitation, we a d d e d b a c k interest expense in the d e n o m i n a t o r of o u r E T R
m e a s u r e a n d m a d e no a d j u s t m e n t to eliminate book-tax timing differences.
the playing field across businesses by reducing tax preferences and broad-
ening the tax base, while reducing the tax rates. 9 For example, TRA86
reduced tax preferences for capital investment by repealing the investment
tax credit and lengthening depreciation schedules. If TRA86 indeed lev-
elled the playing field across firms with different capital structures and
asset mixes, then these characteristics should no longer be associated with
ETRs after tax reform.
The above discussion suggests the following general research hypotheses
examined in our study:
HI: Corporate average effective tax rates are related to firm size after
controlling for the results of firms' operations.
H2: Corporate average effective tax rates are related to firms' financing and
investment decisions after controlling for the results of their operations.
H3: The relation between corporate average effective tax rates and firms'
financing and investment decisions is impacted by TRA86 after con-
trolling for the results of their operations.
2.3 E T R s and Other Firm-Specific Characteristics

Admittedly, a firm's ETR could be related to other factors besides its size,
capital structure, and asset mix. A complete model of ETR variability
would ideally include these other factors. One such factor is the extent of a
firm's foreign operations. Given that the United States imposes taxes on
worldwide income and limits taxpayers' ability to offset foreign income
taxes (via limitations on foreign tax credits), the worldwide ETRs of
companies with foreign operations will likely be higher if they operate in
relatively high tax rate countries. This problem may have been exacerbated
after 1986 as more companies experienced binding foreign tax credit
limitations (Collins and Shackelford 1992, pp. 104-105). Further, because
larger firms tend to have a greater proportion of their income from foreign
operations (Zimmerman 1983, p. 136; Daronco 1990-1991, p. 31), the
extent of a firm's foreign involvement is potentially correlated with its size.
Similarly, a firm's ownership structure, compensation policies, and cor-
porate culture likely impact ETRs. With regard to ownership structure, it
could be argued that the greater the managers' share of ownership in a
firm, the more aggressive they might be in reducing taxes relative to
increasing financial reporting income. Klassen (1996, pp. 18-23) has pre-
9As a fail safe measure, T R A 8 6 also introduced a m o r e stringent alternative m i n i m u m tax for
corporations which, a m o n g o t h e r things, imposed a tax on one-half of the difference between book
and taxable income. This m e a s u r e ensured that profitable corporations which reduced their tax
liabilities via tax preferences not explicitly reduced by T R A 8 6 would pay at least some taxes (i.e.,
have higher tax burdens).
sented evidence consistent with this expectation in the context of man-

agers' decisions to sell assets with unrealized gains or losses; however,
Guenther (1994, pp. 240-241) did not find support for this hypothesis in
his study of earnings management responses to the tax rate reductions
under TRA86. With regard to compensation policies, it is well known that
bonuses are an important component of corporate managers' compensa-
tion, and that they are determined based on either before-tax or after-tax
accounting earnings. Thus, managers' incentives to trade-off between
financial and tax reporting is likely a function of the particular terms of
bonus plans. Finally, with regard to corporate culture, it is possible that
some firms are simply more aggressive than others in pursuing tax-minimi-
zation strategies.
Our empirical model does not include these variables primarily because
data constraints limited our ability to satisfactorily measure a firm's
foreign presence, data on both ownership structure and compensation
policies (although available) are prohibitively expensive to collect for large
samples, and corporate culture is largely unobservable. An advantage of
the panel data analysis used in our study is that it likely accounts for the
effects of these variables if they do not vary greatly over each sample
period. However, to the extent TRA86 altered firms' incentives such that
they changed policies with regard to these variables, the control may be
inadequate and caution is warranted in drawing inferences from the
results, especially those related to TRA86's impact.
3. Research Methods
3.1 Sample Selection
The sample consists of panels of firms from the 1991 Annual Compustat
Industrial File for the periods 1982-1985 and 1987-1990. The periods
were selected so as to construct equally-long panels covering the pre- and
post-TRA86 tax regimes. The year 1986 was excluded because TRA86 was
enacted in that year and studies indicate firms began responding to
changes that were effective in 1987.1 Arguably, the years 1987 and 1988
also represent transition years because some of the TRA86 provisions
were phased in over those years. Hence, our post-TRA86 panel is partially
contaminated and likely has noise which reduced the power of the tests
and weakened the results.
10 See, for example, studies on e a r n i n g s m a n a g e m e n t in response to the e n a c t m e n t of the

alternative m i n i m u m tax b o o k income a d j u s t m e n t ( G r a m l i c h 1991; Dhaliwal a n d W a n g 1992), a n d
studies on income shifting in response to the tax rate decreases in T R A 8 6 (Scholes et al. 1992;
G u e n t h e r 1994).
As mentioned before, the panels were balanced in two ways to satisfy

our research design requirements for longitudinal data. First, each period's
panel (1982-1985 and 1987-1990) contains only those firms with requisite
data in all years of that period, but the same firms were not required to be
in both panels. Second, the two panels were restricted to contain only firms
with requisite data in all eight years. The first approach yielded a final
sample of 823 firms (3,292 firm-years) for 1982-1985 and 915 firms (3,660
firm-years) for 1987-1990. When constrained to include only the same
firms in both panels under the second approach, the final sample size was
655 firms with requisite data in all eight years (5,240 firm-years).
To arrive at the final sample in both cases, the following firms were
deleted from the Compustat file: 1) financial institutions and utilities,
because regulatory constraints faced by these firms were likely to systemat-
ically affect their ETRs differently from other firms; 2) foreign firms,
because these firms may be subject to home country tax laws which differ
from U.S. laws; H 3) firms with no business activity or with missing data for
one or more of the panel years; and 4) firms with net operating loss (NOL)
carryforwards, because their ETRs are difficult to interpret (Wilkie and
Limberg 1993, p. 53). A summary of the sample reconciliation is provided
in Table 1.
3.2 Empirical Model, Data, and Variable Definitions

The empirical analysis in our study consists of estimating ordinary least
squares (OLS) regression models of the following general form:
ETRit = ~0 + ~1SIZEit + ~2LEVit + ~3CAPINTit
+ ~4INV1NTil + flsRDINT, + fl6ROAit , (1)
where the dependent variable, ETRit, is the average effective tax rate for
firm i in year t and the independent variables (with subscripts omitted)
include proxies for firm size (SIZE), capital structure (LEV), asset mix
(CAPINT, INVINT, and RDINT), and firm performance (ROA). The defi-
nition of these variables and measurement issues affecting their computa-
tion are discussed below.
Financial statement data were obtained from Compustat to compute all
variables. Although using financial statement data raises certain problems,
especially in computing ETRs (discussed below), we used these data for
three reasons. First, they are the only source of publicly-available informa-
tion which allows calculation of ETRs and the explanatory variables at the
individual firm-level (Shevlin and Porter 1992, p. 63). Second, much of the
tl Foreign firms are identified on Compustat as those finns with a state identification code of 99,
which indicates that the company's principal location is in a country other than the U n i t e d States.
Table 1. Sample Selection

1982-1985 1987-1990
A l l firm-years o n the 1991 C o m p u s t a t I n d u s t r i a l File

e x c l u d i n g financial institutions, utilities, a n d foreign
firms 6,496 6,496
Less:
N o activity firm-years - 1,609 - 350
F i r m - y e a r s w i t h m i s s i n g d a t a for o n e or m o r e o f the
panel years - 355 - 430
F i r m - y e a r s w i t h net o p e r a t i n g loss c a r r y f o r w a r d s -1,260 -2,056
F i n a l s a m p l e (firm-years) 3,292 3,660

F i n a l s a m p l e ( n u m b e r o f firms) a 823 915
a If the two panels are constrained to have only the same firms in both periods (1982-1985 and
1987-1990), the final sample is reduced to 655 firms (5,240 firm-years over the eight-year period).
media and political attention given to corporate tax burdens has been
based on ETRs obtained from financial statements (e.g., CTJ 1986, pp.
1-2; GAO 1990, p. 2; GAO 1992, p. 2). Finally, Zimmerman (1983, p. 137)
found that the ETRs produced by either financial statement data or
Internal Revenue Service data, complied from aggregated individual cor-
porate tax returns, were similar, and concluded that "financial statement
data yield unbiased estimates of effective tax rates."
3.2.1 Calculation of Effective Tax Rates. Although ETRs are usually

measured as tax liability divided by income, there is considerable contro-
versy regarding the appropriate definition of both the numerator and
denominator. Because the various arguments have been elaborated on at
length elsewhere (e.g., Omer et al. 1991, pp. 59-62; Shevlin and Porter
1992, pp. 63-64; Wilkie and Limberg 1993, pp. 83-85), we limit our
discussion to a select few of these issues and how we resolved them in this
study.
With regard to the numerator of ETR, the question is which taxes
should be considered. We used only the current portion of each firm's
worldwide income tax expense. The deferred portion of the tax expense
was excluded to be consistent with several studies on which the popular
debate on tax burdens has been based (e.g., CTJ 1985, pp. 9-11, 1988, pp.
63-64; GAO 1990, p. 2, 1992, p. 1 3 ) . 12 Further, we used worldwide taxes
12 Some parties strongly oppose excluding deferred taxes on the ground that these taxes are not
forgiven (e.g., Egger 1985). Ideally, one might include the present value of deferred taxes in
calculating ETRs (Clowery, et al. 1986, pp. 994-997), but that is essentially impossible without
knowledge of the probability of reversal for each book-tax timing difference, the time frame for
reversal, and the firm's discount rate. To obtain the current income tax expense, we subtracted the
deferred tax expense amount reported on the income statement from total tax expense. W e did not
use the change in deferred tax liability reported on the balance sheet because Omer et al. (1991, pp.
70-71) found that this approach causes systematic changes in tax and income across firms and over
time which are related to firm size.
(rather than just domestic taxes) partly because disaggregating a firm's

total tax expense into domestic and foreign components is problematic
(Spooner 1986, pp. 300-301; Wheeler 1988). In addition, because firms can
obtain a credit for foreign taxes and deduct state and local taxes, focusing
only on the U.S. federal tax expense would be misleading (Shevlin and
Porter, 1992, p. 62).
With regard to the denominator of ETR, the question centers on the
appropriate measure of income. The alternatives include taxable income,
financial accounting (book) income, and cash flow from operations. We did
not use taxable income because our objective in this study is to capture the
impact of tax preferences on ETRs. If both the numerator (tax expense)
and the denominator (income) are after tax preferences, then any system-
atic variation in ETRs due to tax preferences will not be detected. Further,
the political debate on corporate tax burdens centers on book numbers
(e.g., CTJ 1986, pp. 1-2; GAO 1990, p. 2; GAO 1992, p. 2). Hence, our
primary income measure is based on book income. We also used operating
cash flow as the denominator for an alternate ETR measure because this
measure potentially controls for systematic differences in accounting
method choices which are related to firm size (Zimmerman 1983, p. 123;
Shevlin and Porter 1992, p. 73). For example, larger firms are observed to
generally use income-decreasing accounting methods and accruals (Watts
and Zimmerman 1986, pp. 234-240). Both income measures are defined as
before tax and interest expenses. ~3
Another important measurement issue regarding ETRs concerns firms
with negative income or tax refunds. Although these firms have been
retained in the sample, their ETRs are distorted in certain situations. For
example, the ETR of a firm with a book loss (negative denominator) and a
tax refund (negative numerator) is positive, even though such a firm paid
no taxes. Similarly, the ETR of a firm which paid taxes (positive numera-
tor) in a year it reported a book loss or had negative cash flow (negative
denominator) is negative, even though the firm paid taxes. This problem
is addressed by setting the ETR: 1) to zero for firms with tax refunds; and
2) to 100% for firms with positive taxes and negative (or zero) income or
13Although defining the E T R d e n o m i n a t o r in this m a n n e r was a i m e d at o v e r c o m i n g some

i n t e r p r e t a t i o n problems, especially with Stickney a n d M c G e e ' s (1982, p. 130) E T R m e a s u r e dis-
cussed earlier, o t h e r p r o b l e m s r e m a i n with b o t h b o o k income a n d cash flows. F o r example, b e c a u s e
of differences in the consolidation rules for financial a c c o u n t i n g a n d tax purposes, the r e p o r t e d
b o o k income a n d tax expense may not relate to the same entities (Dworin 1985, pp. 966-967;
W e b e r 1985). In addition, there is no readily accepted definition of cash flows (Wilkie a n d Limberg
1993, p. 48, footnote 8). Thus, w h e r e a s Z i m m e r m a n (1983, p. 123) used sales less cost of goods sold
as his cash flow s u r r o g a t e , Shevlin a n d P o r t e r (1992, p. 73) a r g u e d that both sales a n d cost of goods
sold are affected by a c c o u n t i n g m e t h o d choices a n d suggested their own cash flow definition, which
is similar to the definition used in this study.
cash flow. TM One final measurement issue which chronically affects ratio
variables, such as ETRs, is the effect of denominators with relatively small
values. Because these small values can give rise to ETRs of unreasonable
magnitudes and cause estimation problems, we constrained the ETR of
our sample firms to lie between 0% and and 100%.
In summary, two ETR measures were used as the dependent variable to
assess robustness of the empirical results. 15 The first measure, ETR1, is
defined as the ratio of current worldwide income tax expense to book
income before interest and taxes. The second measure, ETR2, is defined as
the ratio of current worldwide income tax expense to operating cash flows
before interest and taxes.
3.2.2 Explanatory Variables. Firm size (SIZE) is measured as the natural

logarithm of total assets at book value. 16 Financial leverage (LEV), mea-
sured as the ratio of long-term debt to total assets (both at book values),
proxies for firms' capital structures and is included to capture finns'
financing decisions. Given the competing arguments presented earlier
regarding the association between ETRs and firm size and capital struc-
ture, no sign predictions were made for these two variables.
Three variables, one based on prior research (CAPINT) and two new
variables (INVINT and RDINT), which proxy for asset mix were included
to capture firms' investment decisions. Following Stickney and McGee
(1982, p. 131), the first asset mix variable is capital intensity (CAPINT),
defined as the ratio of net property, plant and equipment to total assets
14 T h e r e is n o c l e a r a n s w e r as to the a p p r o p r i a t e coding scheme for these firms. In particular,

firms with a tax r e f u n d a n d negative taxable income actually face a positive m a r g i n a l tax rate and,
by implication, a positive average tax rate. H e n c e , we p e r f o r m e d sensitivity analysis (discussed later)
excluding firms with r e c o d e d E T R s , b u t the results were qualitatively similar.
15 Because of functional a n o m a l i e s related to E T R measures, Wilkie a n d L i m b e r g (1993) sug-
gested the ratio of tax subsidies to equity (TSE) as an alternative to E T R s in assessing tax b u r d e n s
across firms a n d time. However, the T S E m e a s u r e is not without p r o b l e m s of its own. As Shevlin
a n d P o r t e r (1992, p. 64) c o n t e n d e d , by not relating taxes to c u r r e n t income, TSE arguably may not
be an a p p r o p r i a t e tool for evaluating c o r p o r a t e tax b u r d e n s (and, by implication, equity issues).
Given the objective of o u r study, we u s e d E T R as o u r d e p e n d e n t variable and, to the extent
possible, a d d r e s s e d the E T R a n o m a l i e s raised by Wilkie a n d L i m b e r g in the r e s e a r c h design.
F u r t h e r , a l t h o u g h O m e r et al. (1991, p. 71) r e c o m m e n d e d using multiple E T R m e a s u r e s for
sensitivity purposes, we limited o u r analysis to two E T R m e a s u r e s in the interest of parsimony.
Moreover, O m c r et al. (1993, pp. 1 7 9 - 1 8 1 ) showed t h a t the association between firm size a n d tax
b u r d e n is robust to alternative m e a s u r e s of tax r a t e s a n d time periods.
16,d~l a s s e t - b a s e d firm size m e a s u r e was u s e d for two reasons. First, i n c o m e - b a s e d size m e a s u r e s
(e.g., sales) can yield misleading inferences a b o u t the ETR-firm size relation because larger firms
tend to have higher profitability which, in turn, results in higher E T R s (Wilkie a n d L i m b e r g 1990, p.
88). Second, asset-based size m e a s u r e s facilitate c o m p a r i s o n with prior E T R studies (e.g., Stickney
a n d M c G e e 1982, p. 132; P o r c a n o 1986, p. 23). To test for potential nonlinearity in the ETR-firm
size relation, we also included the square of firm size ( S l Z E S Q ) as a r e g r e s s o r in earlier versions of
this paper. However, the P e a r s o n c o r r e l a t i o n b e t w e e n SIZE a n d S I Z E S Q was in excess of .95 in the
data, which p r e v e n t e d e s t i m a t i n g their s e p a r a t e coefficients with a n y r e a s o n a b l e d e g r e e of preci-
sion.
(both at book values). 17 The second asset mix variable is inventory inten-
sity (INVINT), defined as the ratio of inventory to total assets (both at
book values). Given the tax benefits associated with capital investments,
capital-intensive firms should face lower ETRs and, to the extent INVINT
is a substitute for CAPINT, inventory-intensive firms should face relatively
higher ETRs. TMAggregate industry-level evidence provides support for this
hypothesized relation, as firms in the manufacturing sector have been
observed to have lower ETRs relative to firms in wholesale and retail trade
(e.g., Zimmerman 1983, p. 130; Gupta and Newberry 1992, pp. 700-701).
Hence, a negative (positive) relation between ETRs and CAPINT (IN-
VINT) is predicted.
The impact of TRA86 on the relation between ETRs and CAPINT or
INVINT is not clear. In addition to reducing corporate tax rates, TRA86
introduced the following changes which specifically affect these two vari-
ables: 1) repeal of the investment tax credit; 2) depreciation schedules
changed to lengthen useful lives of most assets; and 3) changes initiated in
the accounting for inventory costs which delayed expense recognition while
speeding up revenue recognition. '9 The reduction in tax rates should have
led to lower ETRs, whereas the rule changes should generally have led to
higher ETRs. In addition, the relative impact of the rule changes depends
on the extent to which CAPINT and INVINT are substitutes. Thus, on
balance, whether the relation between ETRs and CAPINT or INVINT was
negatively or positively impacted by TRA86 depends on the relative effects
of the statutory tax rate reductions and the various rule changes which
impacted tax preferences.
The third asset mix variable is the firm's extent of involvement in
research and development (RDINT), defined as the ratio of R & D ex-
penses to net sales. R & D expenses provide an investment-tax shield
because they are immediately deductible, even though benefits are typi-
cally realized over a long-term; further, a tax credit on incremental R & D
expenses is available. These tax benefits suggest a negative relation be-
17 Net (rather than gross) property, plant, and equipment was used to better distinguish between
firms with newer or older assets. A ratio based on a net a m o u n t will give m o r e weight to newer
assets which receive a g r e a t e r share of tax preferences in the form of accelerated depreciation and
investment tax credits.
18 T h e pairwise Pearson correlation coefficient between INVINT and CAPINT for our sample
firms was - 0 . 3 9 ( - 0 . 4 1 ) f o r the periods 1982-1985 ( 1 9 8 7 - 1 9 9 0 ) ( b o t h significant at the .01 level),
which lends credence to these variables being substitutes. Although a firm's inventory m e t h o d
( L I F O versus F I F O ) could also influence its tax liability, these effects would likely not be detected
in our model. As long as firms use the same inventory m e t h o d for both book and tax purposes, the
m e t h o d choice would affect both the E T R n u m e r a t o r and d e n o m i n a t o r (e.g., a L I F O m e t h o d choice
which reduces tax expense would also reduce book income).
19 The changes in accounting for inventory costs include: 1) requiring that a portion of indirect
costs be allocated to an inventory or capital account r a t h e r than to an expense account in the year
incurred; 2) accelerated recognition of installment gains for sales of inventory; and 3) repeal of the
installment m e t h o d for sales pursuant to revolving credit plans.
tween ETRs and RDINT. 2 TRA86 reduced the credit on incremental

R & D expenses from 25% to 20%, thereby likely increasing ETRs (posi-
tive impact) for firms with higher R & D involvement.
Finally, we included firms' returns on assets (ROA) to control for
profitability. ROA, measured as the ratio of pretax income to total assets,
should provide a rough control for the impact of changes in book income.
Based on Wilkie (1988, p. 77), ETRs can be decomposed as follows:
ETR = [
1 PTI t, (2)
where:
TP = tax preferences;
PTI = pretax income;
t = statutory tax rate.
Given our definition of ROA [PTI/total assets (TA)], the relation between
ETRs and ROA can be obtained by rewriting PTI in terms of ROA (i.e.,
PTI -- ROA* TA) and substituting for PTI in equation (2) as follows:
ETR = 1 ROA* T A t . (3)
From equation (3) it follows that, holding TP, t, and TA constant, an

increase in ROA will result in an increase in ETRs, i.e., ROA should be
positively related to ETRs. Further, given that TRA86 reduced both T P
and t, this relation should be negatively impacted by TRA86.
3.3 Panel Data Estimation Procedures for Linear Models

Regression models estimated with panel data have several advantages over
those estimated with cross-sectional or time-series data. 21 In particular, it
is well-known that a simple-pooled cross-section time-series model will not
provide unbiased and consistent parameter estimates if the unobserved
firm-specific characteristic are correlated with the included explanatory
variables. In that case, the simple-pooled model suffers from an omitted
variables bias because the model is misspecified. A fixed-effects model
(FEM) overcomes this problem by accounting for individual firm hetero-
geneity via firm-specific constants (intercepts) in the model which capture
2Altshuler (1988, p. 453) has a r g u e d t h a t the i n c r e m e n t a l structure of the R & D credit c a n give
rise to effective credit rates t h a t are zero o r negative, casting some d o u b t o n this relation. However,
Eisner et al. (1984, p. 171) estimated t h a t the T r e a s u r y ' s revenue loss f r o m the tax credit was over
o n e billion dollars a n n u a l l y b e t w e e n 1983-1985, suggesting that, overall, the tax p r e f e r e n c e for
R D I N T is significant.
21 See C h a m b e r l a i n (1984) a n d H s i a o (1989) for surveys, a n d Slemrod a n d Shobe (1990) for a
discussion of the p a r t i c u l a r benefits of p a n e l d a t a in analyzing b e h a v i o r a l responses to taxation. T h e
discussion in this p a r a g r a p h draws heavily on these sources.
16 S. Gupta and IC Newberry
the effects of unobserved or unmeasurable firm characteristics that vary by

firm, but are relatively stable over time for a given firm. One limitation of
the FEM is that it produces parameter estimates which are conditional or
sample-specific, so inferences are not generalizable outside the sample. A
random-effects model (REM) overcomes this limitation by viewing the
individual-specific characteristic as a normally-distributed random variable;
however, the R E M has its own limitations. Most significantly, the R E M
assumes the individual-specific effects are uncorrelated with the regres-
sors, which is often hard to justify.
As will be discussed in Section 4, we estimated all three models: the
simple-pooled OLS, the FEM, and the REM. Various statistical tests were
then conducted to evaluate the adequacy of these alternate model specifi-
cations.
4. R e s u l t s
4.1 Descriptive Statistics

Table 2 provides descriptive statistics for the ETR measures (panel A) and
the explanatory variables (panel B), as well as detailed definitions of the
Table 2. Descriptive Statistics o f Effective Tax Rates and Explanatory Variables

for the Pre-Tax R e f o r m A c t o f 1986 (1982-1985) and Post-Tax R e f o r m Act o f
1986 (1987-1990) Periods
Panel A: Effective Tax Rates (ETRs) ~

1982-1985 1987-1990
(n = 823 firms; (n = 915 firms;
3,292 firm-years) 3,660 firm-years)
ETR1 ETR2 ETR1 ETR2
Distribution (in %):

Mean 25.53 30.53 27.57 31.22
Standard deviation 18.51 30.46 18.90 29.35
Median 27.38 22.91 28.10 23.71
Frequency (% of n):
ETR less than 10% 368 (11.2%) 483 (14.7%) 250 (6.8%) 384 (10.5%)
ETR between 10% and top
statutory rate b 2202 (66.9%) 1728 (52.5%) 1961 (53.6%) 1864 (50.9%)
ETR greater than top
statutory rate 235 (7.1%) 278 (8.4%) 992 (27.1%) 645 (17.6%)
ETR recodedC 487 (14.8%) 803 (24.4%) 457 (12.5%) 767 (21.0%)
Mean with recoded
observations deleted (in %) 31.07 28.13 30.57 27.55
Table 2 (continued)
Panel B: Explanatory Variables a
1982-1985 1987-1990
( n = 823 firms; 3,292 f i r m - y e a r s ) ( n = 915 firms; 3,660 f i r m - y e a r s )
Variable Mean Std. dev. Median Mean Std. dev. Median
SIZE 5.68 1.85 5.59 5.93 1.89 5.80

LEV 0.17 0.14 0.14 0.20 0.18 0.18
CAPINT 0.35 0.19 0.32 0.34 0.21 0.30
INVINT 0.21 0.14 0.20 0.20 0.16 0.18
RDINT 0.02 0.04 0.00 0.02 0.05 0.00
ROA 0.11 0.10 0.11 0.10 0.11 0.09
a Variable definitions (with Compustat items in parentheses) are as follows:

ETR1 = current income tax e x p e n s e / b o o k income before interest and taxes (EBIT);
ETR2 = current income tax e x p e n s e / o p e r a t i n g cash flow before interest and taxes (OPCF);
SIZE = natural log of total assets (6) in millions of dollars;
LEV = long-term d e b t / t o t a l assets ( 9 / 6 ) ;
CAPINT = net property plant & e q u i p m e n t / t o t a l assets ( 8 / 6 ) ;
INVINT = i n v e n t o r y / t o t a l assets ( 3 / 6 ) ;
R D I N T = R & D e x p e n s e / s a l e s (46/12);
ROA = pre-tax i n c o m e / t o t a l assets ( ( 1 7 0 - 1 7 ) / 6 ) ;
where:
Current income tax expense = total income taxes (16) - deferred taxes (50);
E B I T = earnings before interest and taxes, adjusted for equity in earnings and unusual or
nonrecurring items (170 - 55 - 17 + 15);
Operating cash flow ( O P C F ) = net cash flow from operating activities (308) - extraordinary
items and discontinued operations (124) + interest (15) + income taxes (16 - 50). If
308 = . then,
O P C F = total funds from operations ( 1 1 0 ) - extraordinary items and discontinued operations
(124) + n d e b t in current liabilities (34) + A accounts payable (70) + A other current
liabilities (72) - A debt due in one year (44) - a total current assets (4) + A cash (1)
+ interest (15) + income taxes (16 - 50)
= ( 1 1 0 - 1 2 4 ) + (34 + 70 + 7 2 - 4 4 ) - (34L + 70L + 72L - 4 4 L ) - ( 4 - 1 ) + (4L -
1L) + (15) + (16 - 50), [where L is the variable lagged one year].
b T h e top statutory tax rate used for this purpose was 46% for 1982-1985, 40% for 1987, and 34%
for 1988-1990.
c Recoded E T R s are those observations with distorted E T R s which were coded as 0% or 100%.
See text for details.
variables. For our sample, the mean ETRs range from 25.53% (ETR1 for
1982-1985) to 31.22% (ETR2 for 1987-1990). Given that both ETR
measures have the same numerator and that cash flows usually are greater
than book income, it is somewhat surprising that the mean of the book
income-based ETR1 was smaller than the cash flow-based ETR2 in both
periods. However, consistent with expectations, the medians of the book
income-based ETR1 exceeded the medians of the cash flow-based ETR2.
To investigate this issue further, the sample firms were classified into four
E T R categories which follow the GAO (1990, pp. 24-27) classifications:
ETRs of less than 10% (low); ETRs between 10% and the top statutory
rate (normal); ETRs greater than the top statutory rate (high); and ETRs
which were recoded as 0% or 100% (as discussed before). 22 These data

suggest that the greater proportion of recoded observations (especially to
100%) for ETR2 potentially account for its higher mean. This was con-
firmed by deleting the recoded observations; then (as expected), the mean
of the book income-based ETR1 was higher than the mean of the cash
flow-based ETR2. Although there was no a priori reason to believe that the
relation between ETRs and the explanatory variables included in our
model was systematically different for the recoded observations, we per-
formed sensitivity analysis (reported later) excluding these observations.
A second issue of note pertains to the relative magnitude of the ETRs
pre- and post-TRA86. Given Congress' intent to increase overall corporate
tax burdens, post-TRA86 ETRs are expected to be higher than pre-TRA86
ETRs. Although the means and medians of both ETR measures reported
in Table 2 are indeed slightly higher in the post-TRA86 period, the
magnitude of the increase is less than that observed in prior studies (CTJ
1988, pp. 2-40; GAO 1990, p. 43, 1992, p. 36; Gupta and Newberry 1992,
p. 700; Shevlin and Porter 1992, p. 72), and virtually non-existent when the
recoded ETRs are deleted. 23 Because averaging the ETRs over four years
may have masked the impact of TRA86 on these univariate statistics, we
present in Figure 1 means and medians of the two ETRs by year. These
data show that ETRs of our sample firms increased from 1985 to 1987, but
they steadily declined in each of the next three years.
The descriptive statistics for the explanatory variables show that the
distribution of these variables is generally similar for the pre- and post-
TRA86 periods. A notable exception is an approximate three percentage
point increase in the leverage ratio, which is consistent with Scholes and
Wolfson's (1992, pp. 323-325) argument that TRA86 encouraged corpora-
tions to use more debt financing. 24 The distribution of these variables was
essentially unaffected when those observations with recoded ETRs were
deleted from the sample.
22 The p e r c e n t a g e of observations with E T R s g r e a t e r t h a n the top statutory rate in the pre- a n d

p o s t - T R A 8 6 periods is similar to the G A O (1992, p. 22) study. These relatively high E T R s are likely
related to small values in the d e n o m i n a t o r for b o o k income a n d cash flows. The p e r c e n t a g e of
r e c o d e d observations with the b o o k i n c o m e - b a s e d E T R I is lower than the p e r c e n t a g e of distorted
rate c o m p a n i e s in the G A O (1992, p. 22).
23 F o r example, G u p t a a n d Newberry (1992, p. 700) observed a 4.7 p e r c e n t a g e points increase in
the m a g n i t u d e of p o s t - T R A 8 6 worldwide ETRs, a n d Shevlin a n d P o r t e r (1992, p. 72) a 5.6
p e r c e n t a g e points increase. T h e s e studies generally relied on samples of very large firms a n d did not
delete N O L firms.
24 T R A 8 6 r e d u c e d personal tax rates to a level well below that on c o r p o r a t i o n s (a top rate of 28%
for individuals versus 34% for c o r p o r a t i o n s by 1988), while dramatically increasing capital gains tax
rates. Scholes a n d Wolfson (1992, pp. 323 325) a r g u e d that these tax-rate c h a n g e s (in conjunction
with relatively low interest rates) substantially r e d u c e d the implicit tax on stock to shareholders,
thereby increasing their r e q u i r e d r e t u r n a n d m a k i n g equity an expensive way to finance c o r p o r a t e
investment in the p o s t - T R A 8 6 period.
40
35
O
3O
25
~ETR1 Mean
ETR2 Mean
,v 20
--=Ik-- ETR1 Median
,.q
- , ) 4 - - ETR2 M e d an
15
7~
10
0 I I I I I I I
1982 1983 1984 1985 1987 1988 1989 1990
Year
Figure 1. Corporate Effective Tax Rates Pre-Tax Reform Act of 1986 (1982-1985) and Post-Tax Reform Act of
1986 (1987-1990), where ETR1 = Book Income-Based E T R Measure and ETR2 = Cash Flow-Based E T R Measure.
4.2 Regression Results for the Full Sample

Table 3 summarizes the FEM regression results (coefficient estimates with
t statistics in parentheses) for the pre- and post-TRA86 periods separately.
These results are based on the sample with the two panels containing
overlapping but not exactly the same firms. As described in our research
design, we estimated simple-pooled OLS regression models, as well as
fixed-effects (FEM) and random-effects (REM) models, for each time
period and ETR measure. Based on model specification tests, we found
that the FEM outperformed both the simple-pooled model and the REM. 15
The test results indicate that the unobserved individual-specific effects are:
1) important in that they explain a non-trivial portion of the variability in
corporate ETRs, and 2) likely correlated with the included variables,
leading to biased parameter estimates if they are not accounted for in the
model. Given the superior specification of the FEM, only these results are
presented in Table 3.
All of the regression models in Table 3 were statistically significant at
less than the .01 level, with adjusted RZs ranging from 38.8% (model for
1987-1990 with ETR2) to 48.1% (model for 1982-1985 with ETR1). The
pre-TRA96 models (with both ETR measures) had higher adjusted RZs
than their counterpart models for the post-TRA86 period, which tenta-
tively suggests that the ability of a firm's size, capital structure, asset mix,
and operations to explain variability in ETRs was reduced after TRA86.
Formal tests of TRA86's impact are presented later.
With regard to the individual explanatory variables, one important result
which emerges from Table 3 is the unambiguous impact of firms' operating
characteristics on ETRs. As the table shows, the coefficient on ROA was
positive and significant for both ETR measures and time periods. This
finding underscores the need to explicitly control for firms' incomes before
drawing inferences regarding factors associated with ETR variability, as
has been suggested in recent studies (Wilkie 1988, p. 87; GAO 1990, p. 3;
Shevlin and Porter 1992, p. 65).
25 Various statistical tests exist to evaluate the adequacy of the model specification (e.g., K m e n t a
1986, pp. 625-635; G r e e n e 1993, pp. 466-480 on which the following discussion is based). First,
both the FEM and the R E M can be c o m p a r e d with a simple-pooled model. T h e F E M will
o u t p e r f o r m the simple-pooled model if the null hypothesis of homogeneity of individual-specific
effects (i.e., a 1 = a 2 . . . . . an), which can be tested with the likelihood ratio test or an F test, is
rejected. Similarly, the appropriateness of the R E M relative to the simple-pooled model can be
examined with the Breusch and Pagan Lagrange multiplier (LM) test. Large values of the LM test
statistic (which is distributed as X 2) favor the REM. Finally, the FEM and R E M can be compared
with each o t h e r using H a u s m a n ' s specification test to d e t e r m i n e w h e t h e r the r a n d o m effects are
orthogonal to the regressors. Large values of the test statistics (which is also distributed as X 2)
favor the FEM. In our data, the X 2 statistics for the likelihood ratio and the LM tests were
significant at less than the .01 level, indicating that both the F E M and R E M o u t p e r f o r m the
simple-pooled model. Further, based on the H a u s m a n X 2 statistic, the F E M was found to be
superior to the R E M at the .01 level (two-tailed tests). Finally, we also estimated two-way FEMs
which included both time and firm-specific constants, but found the one-way models including only
firm-specific constants to be b e t t e r specified.
Table 3. Fixed-Effects Regression Results of Effective Tax Rates on Various Firm

Characteristics for Pre-Tax Reform Act of 1986 (1982-1985) and Post-Tax
Reform Act of 1986 (1987-1990) Periods (t statistics in parentheses)
Model: ETR1 or ETR2 = ~ISIZE + fl2LEV + fl3CAPINT + ~41NVINT
+ ~sRDINT + ~6ROA,
where: ETRI = book income-based E T R measure; and
ETR2 = cash flow-based E T R measure.
1982-1985 1987-1990
(n = 823 firms; (n = 915 firms;
3,292 firm-years) b 3,660 firm-years)b
Variable a Predicted sign ETR1 ETR2 ETR1 ETR2
SIZE ? 0.031 0.041 - 0.035 - 0.092

(2.91)** (2.25)** (-3.18)** (-5.33)**
LEV ? - 0.168 0.498 - 0.146 0.039
( - 3.82)** (6.73)** ( - 4.58)** (0.78)
CAPINT - -0.363 -0.522 -0.152 -0.421
(-6.29)** (-5.37)** (-2.47)** (-4.36)**
INVINT + 0.085 0.689 0.239 0.602
(1.17) (5.65)** (3.13)** (5.02)**
RDINT - 0.078 - 0.683 0.091 0.192
(0.40) ( - 2.09)** (0.56) (0.75)
ROA + 0.462 1.131 0.210 0.618
(9.14)** (13.28)** (4.62)** (8.70)**
Adjusted R 2 0.481 0.456 0.400 0.388
Hausman X 2 53.67 41.92 38.89 46.67
(two-tailed p value) (0.01) (0.01) (0.01) (0.01)
**(*)Denotes significance at the .05 (.10) level. Two-tail (one-tail) critical values were used for
non-directional (directional) predictions.
a See Table 2 for variable definitions.
b The panels are balanced within each four-year period but not over both periods.
The proxy for firm size (SIZE) provides evidence related to hypothesis 1.
In the pre-TRA86 period, SIZE has a positive and significant association
with both ETR measures, which provides support for the political cost
hypothesis that larger firms face higher tax burdens. This result is also
consistent with the univariate evidence in Zimmerman (1983, pp. 126-127)
for an earlier period, and with Kern and Morris' (1992, pp. 91-92)
extension of those results to the pre-TRA86 period, albeit both studies
define as large only those 50 firms with the greatest sales revenues. In the
post-TRA86 period, SIZE has a negative and significant association with
both ETR measures. This result is consistent with the political clout
hypothesis that larger firms are better able to reduce their explicit tax
burdens, and with evidence in Siegfried (1972, pp. 249-254) and Porcano
(1986, p. 23), although their findings are based on data for earlier periods.
However, the firm size results also differ from several other studies. For
example, the results are diametrically opposed to the CTJ's (1985, pp.
1-15; 1988) claim that large firms had lower ETRs pre-TRA86 but higher
ETRs post-TRA86. The results are also inconsistent with studies which
found no association between ETRs and firm size (Stickney and McGee
1982, pp. 142-143; Shevlin and Porter 1992, p. 76).
Our firm size results, especially the change in the signs of the estimated
coefficients from positive in the pre-TRA86 period to negative in the
post-TRA86 period, are somewhat puzzling because the thrust of TRA86
was to increase corporate tax burdens, and large corporations appeared to
be specifically targeted for the increase. Although unlikely, a potential
explanation for our results is simply that TRA86's tax rate reductions more
than offset its base-broadening provisions for larger firms relative to
smaller firms. Perhaps a more plausible explanation is that the ETR-firm
size relation is sensitive to the sample composition, especially in view of
the wide disparity in the results reported in the literature. This likelihood
is enhanced with our own results (reported later) which did not indicate
any SIZE effects when the sample was limited to firms with longer
histories (i.e., firms which had data for the entire eight-year period,
1982-1985 and 1987-1990).
The results for the other explanatory variables provide evidence regard-
ing the association between ETRs and firms' capital structures and asset
mixes (hypothesis 2). As Table 3 shows, with the book-income based ETR1,
the coefficient on LEV was significant and negative both before and after
TRA86. This result is consistent with the argument that larger interest tax
shields lead to lower ETRs. However, the positive and significant associa-
tion of LEV in the pre-TRA86 period with the cash-flow based ETR2 is
consistent with the alternate argument that firms with high marginal tax
rates are more likely to use debt financing. Given that both ETR measures
have the same numerator, the reversal in the sign of the coefficient
estimates of LEV indicates that the relation between ETRs and LE is
sensitive to the income measure used in the denominator of ETR. This
finding makes it difficult to draw unambiguous inferences about the impact
of firms' capital structures on their ETRs.
The results for the asset mix variables generally indicate that there is an
important association between these variables and firms' ETRs. Specifi-
cally, the coefficient in CAPINT was negative and significant and the
coefficient on INVINT was positive and generally significant in both the
pre- and post-TRA86 periods, regardless of the ETR measure. These
results provide evidence that firms with a larger proportion of fixed assets
tend to have lower ETRs as a result of tax preferences, whereas firms with
a greater proportion of inventory (which do not have those tax shields)
tend to have higher ETRs. These findings are consistent with Stickney and
McGee's (1982, p. 142) results for capital intensity, and with prior aggre-
gate industry-level evidence of higher ETRs in the manufacturing sector
relative to the trade sector (e.g., Zimmerman 1983, p. 130; Gupta and
Newberry 1992, pp. 700-701). However, the results for RDINT are not as
strong--the coefficient was negative as predicted and significant only in
the pre-TRA86 period with ETR2.
4.3 Control for Industry-Membership and Other Sensitivity Tests

4.3.1 Controlfor Industry-Membership. The above analysis does not con-
trol for firms' industry-membership, which potentially could be important
for at least two reasons. First, the political debate on distribution of tax
burdens has focused on both large firms and specific industries which may
have benefitted disproportionately from certain tax preferences, and indus-
try-level ETRs have been used as a justification for tax reform (e.g., U.S.
Congress, Joint Committee on Taxation 1987, pp. 524-530). For example,
TRA86 drastically curtailed the deferral available under the completed
contract method of accounting for long-term construction contracts be-
cause of claims that the defense industry's lower ETRs were largely due to
this deferral (U.S. Congress, Joint Committee on Taxation 1987, pp.
524-530). Second, some of the explanatory variables in the model, particu-
larly firms' capital structures and asset mixes, are known to systematically
vary by industry. Thus, not including industry-membership could result in a
correlated omitted variable problem.
To empirically address the above issues, we performed the analysis by
industry groups defined at the one-digit SIC code. Analysis with finer
industry classifications was not feasible because of the precipitous decline
in sample sizes by industry. Although the one-digit level classification is
comparable to prior research (e.g., Zimmerman 1983, p. 129; Kern and
Morris 1992, p. 89), it is rather broad and, thus, the primary value of this
analysis is descriptive.
Table 4 provides descriptive statistics of ETRs by industry groups for the
pre- and post-TRA86 periods. Consistent with prior evidence, these statis-
tics reveal wide variation in the industry-level ETRs for our sample firms.
Two notable trends emerged from comparing the pre- and post-TRA86
ETRs. First, ETRs for most industry groups increased after tax reform,
which is consistent with TRA86's objective to increase overall corporate
tax burdens, and with our earlier results. The exception to this trend is the
wholesale and retail trade firms (SIC code 5), the ETRs of which declined
after TRA86. Second, the range in ETRs across the different industry
groups was somewhat narrower in the post-TRA86 period, which is consis-
tent with TRA86's intent of levelling the playing field. As shown in Table
4, ignoring SIC code 1 (which had some extreme values) and focusing on
the medians, we found that ETR1 (ETR2) ranged from 19% to 29% (21%
to 28%) pre-TRA86, compared with 25% to 29% (21% to 26%) post-
TRA86.
We also estimated regression models separately for each industry group

to generate results similar to those presented in Table 3, but at the
industry level. In general, these results were similar to the full sample
results reported earlier, which provides some comfort that those results
are robust to the exclusion of industry-membership. Hence, we will not
formally present the industry-level results.
4.3.2 Other Sensitivity Tests. To further evaluate the robustness of the

full sample results, we performed a number of other sensitivity tests. The
tests included regression diagnostics for multicollinearity and outlier prob-
lems, and changes in the sample composition to either include firms with
NOLs or delete firms with recoded ETRs. In general, the results were
qualitatively similar to those in Table 3. Specifically, the coefficient esti-
mates had similar signs and significance levels, but the explanatory power
of the models including NOL firms was substantially lower (consistent with
the concerns expressed in the literature regarding these firms), whereas
the explanatory power of models deleting firms with recoded ETRs was
markedly higher. 26
In summary, the Table 3 results provide evidence of systematic associa-
tions between ETRs and several firm-specific characteristics both before
and after TRA86.
4.4 Results for the Impact of TRA86

Although the Table 3 results allow for general comparisons between the
pre- and post-TRA86 periods, they do not allow for formal tests of
TRA86's impact because the two panels do not contain the same firms.
Hence, in Table 5 we present results of regression models that are
identical to those in Table 3 except that they were estimated using a single
balanced panel containing only those Table 3 firms with data for all eight
years (1982-1985 and 1987-1990). This constraint reduced the sample size
to 655 finns (5,240 firm-years). As before, though we estimated the
26 The diagnostic tests suggested by N e t e r et al. (1990, pp. 3 9 7 - 4 0 0 , 4 0 7 - 4 1 1 ) were used to

examine multicoUinearity a n d outlier problems. In general, multieollinearity does not a p p e a r to be
an issue in the d a t a (Pearson pairwise c o r r e l a t i o n coefficients are less t h a n .40 a n d variance
inflation factors are within the acceptable range). F o r outlier analysis, outlier Y observations were
first identified b a s e d on c o m p a r i n g studentized deleted residuals to the .01 tail a r e a of a t
distribution, a n d t h e n estimating the models without these observations. This analysis revealed that:
1) relatively few observations (between 51 to 123 observations d e p e n d i n g on the time period a n d the
E T R m e a s u r e ) were identified as outliers; a n d 2) the e x p l a n a t o r y variables generally b e c a m e m o r e
statistically significant. To examine the impact of including N O L firms, the regression models were
e s t i m a t e d with a n additional variable for N O L status, defined either as a d u m m y for the existence
of a N O L or as a c o n t i n u o u s m e a s u r e of the m a g n i t u d e of the N O L c a r r y f o r w a r d ( C o m p u s t a t item
#52). Finally, when observations with r e c o d e d E T R s were deleted, results for two variables were
c h a n g e d in the p r e - T R A 8 6 p a n e l - - t h e coefficients on SIZE with E T R I a n d R D I N T with ETR2 were
no longer significant.
Table 4. Distribution of Effective Tax Rates (in Percent) by Industry Membership,

Pre- and Post-Tax Reform Act of 1986
(ETR1 = Book Income-Based ETR Measure, and
ETR2 = Cash Flow-Based ETR Measure)
1982-1985 1987-1990
Industry
(one-digit) ETR1 ETR2 ETR1 ETR2
SIC code) a n b Mean Median Mean Median n Mean Me di a n Me a n Median
1 252 17.94 6.00 24.56 3.76 272 20.20 17.55 24.27 11.30
2 924 27.24 29.28 27.28 22.87 1032 28.37 29.10 29.57 23.69
3 1244 25.84 27.61 30.69 22.90 1280 29.36 29.36 34.09 26.05
5 492 28.79 32.27 37.22 28.24 612 26.88 29.09 32.84 25.30
7/8 360 21.29 19.18 33.21 20.95 444 26.32 24.96 29.09 20.96
a The industry groups represented by the one-digit SIC codes can be broadly classified as follows:
SIC code lxxx: extractive resources (mining, petroleum, construction).
SIC code 2xxx: non-durable manufacturing (food, textiles, paper, chemical).
SIC code 3xxx: durable manufacturing (ion & steel, machinery, autos).
SIC code 5xxx: trade (wholesale and retail).
SIC code 7xxx: miscellaneous services (hotels, advertising, others).
SIC code 8xxx: professional services (health, engineering, other).
hn = firm years. The number of firms for each industry group can be obtained by dividing the
number of firm-years by four.
simple-pooled OLS, the FEM, and the REM, we present only the F E M
results as that was the superior specification.
To provide formal tests of TRA86's impact (hypothesis 3), the models in
Table 5 include a period dummy, D-TRA86 (coded 1 if the observation is
for the post-TRA86 period and 0 otherwise), and interaction terms com-
prised of this dummy multiplied with each of the explanatory variables.
The coefficient on D-TRA86 provides a test for a mean shift in ETRs after
tax reform. 27 Given the intent of TRA86 to increase corporate tax bur-
dens, this coefficient is expected to be positive. Further, the coefficients on
the interaction terms allow testing for slope shifts in each of the explana-
tory variables after TRA86, and thus shed light on whether these associa-
tions were changed after TRA86. As in Table 3, however, the coefficients
on each of these explanatory variables provide evidence regarding their
associations with ETRs in the pre-TRA86 period, whereas the sum of
these coefficients and the coefficients of their corresponding interaction
terms with D-TRA86 provide evidence on whether these explanatory
variables were associated with E T R s after TRA86. Any differences in
these results from those in Table 3 are due solely to the use of the
fully-balanced panel. The coefficient estimates, together with t statistics
27 Note that no intercept is reported in either Table 3 or 5 because all intercepts in a FEM are
considered firm-specific. Nevertheless, the coefficient (/37) on the D-TRA86 dummy in Table 5 is
interpreted in the usual manner as representing a mean shift in ETRs.
26 S. G u p t a a n d K. N e w b e r r y
Table 5. F i x e d - E f f e c t s R e g r e s s i o n R e s u l t s o f E f f e c t i v e T a x R a t e s o n V a r i o u s F i r m
Characteristics for a Balanced Panel of Firms over the Pre- and Post-Tax Reform
A c t o f 1986 P e r i o d s , 1 9 8 2 - 1 9 8 5 a n d 1 9 8 7 - 1 9 9 0
( n = 655 F i r m s ; 5,240 F i r m - Y e a r s )
Model: ETR1 or ETR2 = fllSIZE + fl2LEV + fl3CAPINT + 041NVINT + 05RDINT

+ fl6ROA + 07D-TRA86 + 0sD-TRA86*SIZE
+ 09 D- TRA86*LEV + fllo D- TRA86*CAPINT
+ 011D-TRA86*INVINT + 012 D-TRA86*RDINT
+ 013 D-TRA86*ROA,
where: ETR1 = book income-based E T R measure; and ETR2 = cash flow-based E T R m e a s u r e
Panel A: Coefficient Estimates (with t statistics in parentheses)

Variable a Predicted sign ETR1 ETR2
SIZE ? 0.006 - 0.009

(0.99) ( - 0.86)
LEV ? - 0.049 0.321
( - 1.42) (5.77)* *
CAPINT - - 0.127 - 0.489
( - 3.16)** ( - 7.59)**
INVINT + 0.104 0.396
(2.07)* * (4.90)* *
RDINT - - 0.117 - 0.535
( - 0.59) ( - 1.67)**
ROA + 0.733 1.275
(15.76)* * (17.08)* *
D-TRA86 + 0.192 0.050
(9.47)** (1.55)*
D-TRA86*SIZE ? - 0.008 0.007
( - 3.20)* * (1.82)*
D-TRA86*LEV .9 - 0.158 - 0.313
( - 4.48)* * ( - 5.52)* *
D-TRA86*CAPINT ? 0.056 O.138
(2.08)** (3.18)**
D-TRA86*INVINT ? - 0.152 - 0.050
( - 4.72)** ( - 0.96)
D-TRA86*RDINT + 0.422 - 0.036
(2.93)** (-0.16)
D-TRA86*ROA - - 0.608 - 0.531
( - 10.83)** ( - 5.88)**
Adjusted R 2 0.332 0.335
Hausman X2 59.12 24.74
(two-tail p value) (0.01) (0.025)
for the regression models, are presented in panel A of Table 5, a n d the

t statistics for tests of the coefficient sums are presented in panel B of
T a b l e 5.
With the exception of firm size, the Table 5 results generally support the
associations observed in Table 3 between ETRs and the explanatory
variables in both the pre- and post-TRA86 periods. In addition, Table 5
Table 5 (continued)
Panel B: t Statistics for Hypothesis Tests of Significance of Explanatory Variables in the
Post-TRA86 Period Based on the Coefficient Estimates Presented in Panel Ab
Explanatory Variable: Hypothesis ETR1 ETR2
SIZE: ~1 + /38 = 0 --0.18 --0.18

LEV: /32 q- ~9 = 0 --8.17"* 0.19
CAPINT: /33 +/31o = 0 -1.89" -5.86**
INVINT: ~4 -~- ~11 = 0 -0.94 4.23**
RDINT: /3s +/312 = 0 1.42 -1.66"
ROA: /36 + /313 = 0 2.50** 9.29**
**(*)Denotes significance at the .05 (.10) level. Two-tail (one-tail) critical values were used for
non-directional (directional) predictions.
a Variables are defined as in Table 2. D-TRAg6 is a dummy variable coded 1 if the observation is
for the post-TRA86 period (1987-1990) and 0 if from the pre-TRA86 period (1982-1985).
b The t statistics were computed as follows: ( l~i + flj)/[Var( ~i ) + Var(fly) + 2 coy( ~i, ~j)]l/2
provides several new insights. First, as expected, the coefficient on D-TRA86

is positive and significant with both ETR measures. This result implies that
average ETRs increased in the post-TRA86 period (after controlling for all
other variables in the model), which is consistent with the legislative intent
behind TRA86 and with the univariate evidence provided in prior studies
(e.g., CTJ 1988, p. 2-40; G A d 1990, p. 43, 1992, pp. 36; Gupta and
Newberry 1992, p. 700; Shevlin and Porter 1992, p. 72; Manzon and Smith
1994, p. 356). Given TRA86's opposing effects of reduced tax rates and an
increased tax base (and the fact that changes in income were controlled for
in our model), the positive coefficients on D-TRA86 also suggest that the
base-broadening rule changes dominated the rate changes. This finding is
consistent with Shevlin and Porter's (1992, p. 70) results based on a
decomposition of the change in ETRs into income, rate, and rule changes.
Second, the coefficients on the interaction terms between D-TRA86 and
most of the explanatory variables are significant, which indicates that the
relation between ETRs and these variables underwent a nontrivial change
after TRA86. For example, the coefficients on D-TRA86*CAPINT are
positive and significant, and the coefficients on D-TRA86*INVINT are
negative (but significant only with ETR1), which indicates that capital-
intensive firms experienced an increase and inventory-intensive firms a
decrease in their ETRs after TtLA86. This result reinforces the greater
impact of the base-broadening rule changes relative to the tax rate
reductions. Similarly, the coefficient on D-TRA86* RDINT is positive and
significant with the book income-based ETR1, which is consistent with the
lower R & D credit contributing to an increase in ETRs for firms with high
research involvement. Further, the negative and significant relation be-
tween D-TRA86*ROA for both ETR measures is consistent with the
expected impact of the tax rate reductions introduced by T1LA86. Finally,
the coefficients on D-TRA86* SIZE are significant, but the opposing signs
with the two ETR measures make it difficult to draw unambiguous
inferences regarding TRA86's impact on different size finns.
Finally, the coefficient estimates on SIZE were neither significant before
nor after TRA86 with either ETR measure, implying that finn size is not
associated with ETRs in these results. This finding is consistent with the
univariate results in Shevlin and Porter's (1992, p. 76) comparison of very
large finns with a matching control sample of small finns, and in Kern and
Morris' (1992, p. 92) study for the post-TRA86 period. The result is also
consistent with prior evidence based on multivariate tests with large
samples similar to ours, such as the cross-sectional evidence with pre-ERTA
data in Stickney and McGee (1982, pp. 142-143) and the evidence on
changes in worldwide ETRs between the pre- and post-TRA86 periods in
Manzon and Smith (1994, p. 358). However, this result does not support
the contention in studies such as the CTJ's that ETRs vary by firm size,
and it also contrasts with our own results in Table 3 where we found
significant finn size effects. Recall, however, that the only difference
between Table 3 and Table 5 is that they used different samples; only
those Table 3 finns which had data for the entire eight-year period
(1982-1985 and 1987-1990) were retained for Table 5. The different
results suggest that firm size effects may be sample-specific and likely to
not exist over time in firms with longer histories.
For sensitivity purposes, we also estimated the Table 5 results after
deleting finns with recoded ETRs. As before, the fit of these models
improved, but some of the significant slope shifts in the explanatory
variables after tax reform were rendered insignificant.28 However, the
deletion had no impact on the negative and significant finding for D-
TRA86* ROA with either ETR measure, and the D-TRA86* INVINT results
actually became stronger (i.e., the ETR2 coefficient on D-TRA86* INVINT
became significant). More importantly, the deletion virtually had no impact
on the hypotheses tests presented in panel B which show the continued
association of ETRs with several firm-specific characteristics. In fact,
significant negative associations were also observed for LEV (with ETR2)
and SIZE (with ETR1), but CAPINT's association with ETR1 became
insignificant.
5. Summary and Conclusions

Our paper has examined the determinants of variability in corporate ETRs
in a multivariate framework, using micro-level longitudinal (panel) data
spanning two tax regimes. Overall, our results suggest that ETRs are
28 Specifically, the coefficients on D-TRA86*SIZE with both E T R measures, the coefficients on

D-TRA86*LEV and b - T R A 8 6 * R D I N T with E T R I , and the coefficient on D-TRA86*CAPINT with
ETR2 b e c a m e insignificant.
associated with many finn-specific characteristics such as size, capital

structure, asset mix, and profitability. Moreover, the finding that the
fixed-effects regression model provides a superior specification over a
simple-pooled model indicates that certain other unobserved firm-specific
factors have an important and nontrivial relation with ETRs, and that
these unobserved variables are likely correlated with the included vari-
ables. Thus, standard cross-sectional and time-series tests of an association
between ETRs and other variables of interest are biased and inconsistent.
In particular, results of prior studies which have focused on the univariate
relation between ETRs and firm size could be misleading.
With regard to firm size, the variable which has generated the most
attention in the political arena, our results indicate that when viewed over
time and with firms with longer histories, ETRs are not related to firm size
either before or after TRA86. Although this result generally is consistent
with studies which have examined the ETR-firm size relation in a multi-
variate framework (Stickney and McGee 1982; pp. 142-143; Manzon and
Smith 1994, p. 358), it tends to be sample-specific. When we used larger
panels that include firms with shorter histories, we observed a significant
association for firm size. However, the association was not consistently
positive or negative, which indicates that the firm size-ETR relation also
varies over time. In fact, we found that larger firms were associated with
higher ETRs before TRA86 and lower ETRs after TRA86 ceteris paribus,
which does not support the univariate results of CTJ (1988) and similar
studies. 29
Our paper also contributes to the policy debate on corporate tax
burdens on other dimensions. In particular, the finding that ETRs are
systematically related to firms' asset mixes calls into question the tendency
of interest groups to focus simply on firm size to draw inferences about
equity within the tax system. This finding reinforces Stickney and McGee's
(1982, p. 127) caution about interpreting results of studies examining the
non-neutrality of the corporate tax system by focusing on only a single
variable at a time. In addition, although the results indicate that the
association between ETRs and firms' asset mixes has undergone a struc-
tural shift since TRA86, these firm-specific characteristics have continued
29 Supplemental analysis provides additional support that the differences between our firm size
results and those in prior univariate studies may also be attributable to the multivariate framework
used in our study. To further investigate this issue, we estimated the Table 3 results with only SIZE
in the model and Table 5 results with only SIZE, D-TRA86, and D-TRA86*SIZE in the model.
Although we estimated all three models as before (simple-pooled, FEM, and REM), the simple-
pooled model provides the appropriate comparison with the prior univariant studies, as both the
FEM and R E M regressions incorporate controls for unobserved firm-specific characteristics and,
thus, are not strictly univariate regressions. The simple-pooled OLS results show that the estimated
coefficient on SIZE was negative and generally significant (at the .05 level, two-tail) in the
pre-TRA86 period for both E T R measures and both samples. The estimated coefficients continued
to be generally negative in the post-TRA86 period, hut the frequency and magnitude of their
statistical significance was reduced.
to be significantly associated with ETRs. This finding casts doubt on the

claim that TRA86 levelled the playing field among firms. Finally, as recent
studies have cautioned (Wilkie 1988, p. 87; GAO 1990, p. 3; Shevlin and
Porter 1992, p. 65), the results indicate the importance of controlling for
changes in firms' operations (profitability) when examining factors associ-
ated with variability in ETRs.
The above conclusions and implications are subject to certain caveats. A
potentially important limitation is the omission of implicit taxes from the
analysis. Implicit taxes arise because prices of tax-favored assets are bid up
in the marketplace, causing pretax rates of returns for such assets to be
lower than fully-taxed assets. 3 Given differences in the tax treatment of
various assets, corporations are likely subject to implicit taxes. ETRs focus
only on explicit tax burdens (i.e., the amount of taxes paid to tax authori-
ties) and, as such, are only a partial measure of corporations' total tax
burdens. Specifically, while the denominator of ETR includes income from
tax-favored assets, the numerator does not include the implicit taxes
associated with those assets. It is unclear what, if any, influence implicit
taxes may have on the results of our study. If their only impact is to
measure the magnitude of ETRs with error, then the basic inferences
remain unaltered. However, if they are systematically associated with the
individual explanatory variables included in this study, then caution is
warranted in drawing policy implications from any ETR study, including
this one.
Another limitation is that our model of ETRs is not complete. Although
we have gone beyond prior research by including variables which proxy for
important influences on ETRs, there are other likely candidates. For
example, agency theory might offer certain predictions regarding the
association between ETRs and firms' ownership structures and compensa-
tion policies. Similarly, while we considered structural changes in the
relation between ETRs and firms' financing and investment behaviors over
time (across tax regimes), other sources of structural changes, such as
those due to corporate reorganization through mergers and acquisitions,
were ignored. Although this problem was somewhat mitigated in our study
by the use of longitudinal data that followed the same firms over time, it
was certainly not eliminated. We leave these issues for future research.
We have benefitted from the helpful suggestions of Fran Ayres, Charles Ballard, Janet
Meade, Dan Murphy, Siva Nathan, Pat Wilkie, and especially Bruce Behn, Terry Shevlin, and
Gary Weber, on earlier drafts of the paper. Comments of participants at Texas Tech
University's accounting colloquium and the doctoral seminar at the University of North Texas
3o See Scholes and Wolfson (1992, pp. 83-89) for a more complete explanation of implicit taxes.
are greatly appreciated. We also acknowledge the comments and suggestions of two anony-
mous reviewers. Financial assistance to the first author under the Price Waterhouse Fellow-
ship Program in Taxation is gratefully acknowledged.
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NORIH- B(MJAND

Determinants of the Variability

Sanjay Gupta and Kaye Newberry

Address correspondence to: Sanjay G u p t a , School of Accountancy, College of Business, Arizona

Journal of Accounting and Public Policy, 16, 1-34 (1997)

these relations, ETRs have continued to be associated with several firm-

2. Prior Research and Hypotheses Development

Based on an increase in ETRs during the post-TRA86 period for a similar

statistically significant either before or after TRA86. Thus, Shevlin and

2.2 ETRs and Firms' Operations and Financing

2.3 E T R s and Other Firm-Specific Characteristics

sented evidence consistent with this expectation in the context of man-

10 See, for example, studies on e a r n i n g s m a n a g e m e n t in response to the e n a c t m e n t of the

As mentioned before, the panels were balanced in two ways to satisfy

3.2 Empirical Model, Data, and Variable Definitions

Table 1. Sample Selection

A l l firm-years o n the 1991 C o m p u s t a t I n d u s t r i a l File

F i n a l s a m p l e (firm-years) 3,292 3,660

3.2.1 Calculation of Effective Tax Rates. Although ETRs are usually

(rather than just domestic taxes) partly because disaggregating a firm's

13Although defining the E T R d e n o m i n a t o r in this m a n n e r was a i m e d at o v e r c o m i n g some

3.2.2 Explanatory Variables. Firm size (SIZE) is measured as the natural

14 T h e r e is n o c l e a r a n s w e r as to the a p p r o p r i a t e coding scheme for these firms. In particular,

tween ETRs and RDINT. 2 TRA86 reduced the credit on incremental

ETR = 1 ROA* T A t . (3)

From equation (3) it follows that, holding TP, t, and TA constant, an

3.3 Panel Data Estimation Procedures for Linear Models

the effects of unobserved or unmeasurable firm characteristics that vary by

4.1 Descriptive Statistics

Table 2. Descriptive Statistics o f Effective Tax Rates and Explanatory Variables

Panel A: Effective Tax Rates (ETRs) ~

Distribution (in %):

Variable Mean Std. dev. Median Mean Std. dev. Median

SIZE 5.68 1.85 5.59 5.93 1.89 5.80

a Variable definitions (with Compustat items in parentheses) are as follows:

which were recoded as 0% or 100% (as discussed before). 22 These data

22 The p e r c e n t a g e of observations with E T R s g r e a t e r t h a n the top statutory rate in the pre- a n d

4.2 Regression Results for the Full Sample

Table 3. Fixed-Effects Regression Results of Effective Tax Rates on Various Firm

SIZE ? 0.031 0.041 - 0.035 - 0.092

4.3 Control for Industry-Membership and Other Sensitivity Tests

We also estimated regression models separately for each industry group

4.3.2 Other Sensitivity Tests. To further evaluate the robustness of the

4.4 Results for the Impact of TRA86

26 The diagnostic tests suggested by N e t e r et al. (1990, pp. 3 9 7 - 4 0 0 , 4 0 7 - 4 1 1 ) were used to

Table 4. Distribution of Effective Tax Rates (in Percent) by Industry Membership,

Model: ETR1 or ETR2 = fllSIZE + fl2LEV + fl3CAPINT + 041NVINT + 05RDINT

Panel A: Coefficient Estimates (with t statistics in parentheses)

SIZE ? 0.006 - 0.009

for the regression models, are presented in panel A of Table 5, a n d the

Explanatory Variable: Hypothesis ETR1 ETR2

SIZE: ~1 + /38 = 0 --0.18 --0.18

provides several new insights. First, as expected, the coefficient on D-TRA86

5. Summary and Conclusions

28 Specifically, the coefficients on D-TRA86*SIZE with both E T R measures, the coefficients on

associated with many finn-specific characteristics such as size, capital

to be significantly associated with ETRs. This finding casts doubt on the

Dworin, L. Dec. 2, 1985. On estimating corporate tax liabilities from financial

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