05/01/2014 03:14 pm ET Updated Jul 01, 2014

High-Ability Managers Save Their Shareholders Millions in Corporate Income Taxes

Each year, the majority of public companies in the United States pay 20 to 40 percent of pretax income to the government in the form of income taxes. Since every dollar of taxes paid is a dollar that cannot be reinvested within an organization, paying taxes could be considered an inefficient utilization of resources.

Recognizing this inefficiency, managers and shareholders alike are interested in tax minimization strategies. Previous studies have generally examined how corporate tax planning varies with firm-level characteristics such as the location of foreign operations, investments in R&D and capital expenditures, all of which provide companies with valuable tax benefits. However, a recent study from the McDonough School of Business investigates the influence and impact of individual managers on corporate tax strategies.

In the study "Does operational efficiency spill over onto the tax return?" my co-authors Professor Terry Shevlin (University of California -- Irvine) and Professor Dan Wangerin (Michigan State University) and I find that managers with greater ability to efficiently utilize firm resources for revenue-generating purposes engage in greater tax planning. Using data from more than 7,800 U.S. public companies and their management teams over the period from 1994 to 2010, we found higher ability managers are able to structure their R&D activities, capital expenditures and foreign operations more tax-efficiently than their lower ability industry peers. Whether they possess tax-specific expertise or hire external consultants for help, high ability managers can reduce cash outflows to taxing authorities -- boosting available working capital that can be used to either fund their company's already efficient operations or increase payouts to shareholders.

Quantifying the Tax Savings
The combined U.S. federal and state statutory corporate tax rate is about 42 percent. Based on the managerial ability metric we use in our study, the top 10 percent of management teams pay taxes at a rate of only 25 percent of their firms' pre-tax income. The average pretax income for these companies is $211 million, which translates to more than $35 million in annual tax savings per firm. We also examined changes in tax planning around CEO turnovers as well as the executive turnover events to provide stronger casual inferences. When a lower ability CEO is replaced with a higher ability CEO, firms experience more than a three percent decline in cash-based effective tax rates during the three years following the turnover (relative to the three years prior to the change in leadership).

Identifying High-Ability Managers
In the study, we define managerial ability as a manger's capacity to maximize the efficiency of an organization's resources that are used for revenue-generating purposes. We rely on a recently developed metric of how efficiently managers convert investments in corporate resources (e.g., inventory, fixed assets, intangibles) into revenues relative to their industry competitors. After taking into account other firm-specific factors enabling the firm to operate more efficiently (e.g., size, market share, free cash flow), this statistically-based metric distinguishes which managers are most efficient... that is, those that are most productive with their firm's limited resources. These leaders have a superior understanding of the environment in which their firm operates and emphasize maximizing revenues and minimizing costs.

Benefits of Tax Planning
While the same incentives to reduce income taxes also exist to reduce operating costs, reductions in operating costs can negatively impact firm operations. For example, reducing advertising expenditures may reduce future sales, reducing product input costs by purchasing inferior materials may result in lower quality products, and reducing employee compensation may hinder a firm's ability to attract and retain a high-quality work force. Efficiently utilizing resources through tax planning is an appealing strategy to higher-ability managers because reducing tax payments will not adversely affect a firm's operations.

Managerial ability affects both the efficiency of firm operations and the firm's ability to achieve significant tax savings. Quantifying the effect of managerial ability on corporate tax planning should help board members better understand the benefits of hiring executives who can align tax and business strategies.

Allison Koester is an assistant professor of accounting at Georgetown University's McDonough School of Business. An expert on corporate taxes, financial reporting and financial misconduct, Koester has presented her research at more than 30 academic institutions and conferences.