Why do not all firms engage in tax avoidance?


Empirical evidence suggests that there is substantial cross-firm variation in tax avoidance. However, this variation is not well understood. This paper provides a theoretical background for testing, and thus explaining, cross-firm differences in tax avoidance. We develop a formal model with two agents to analyze the incentives that lead firms to engage in tax avoidance. The tax avoidance decision is a function of moral hazard, tax-planning costs, and the potential to increase earnings. If the potential to increase earnings is low, the tax-planning decision is determined by moral hazard problems. In contrast, when this potential is high, the tax-planning decision is mainly driven by tax-planning costs, such as reputational and political costs. One implication of our model is that moral hazard can (partly) explain why some firms do not engage in tax avoidance: Severe problems of moral hazard make tax avoidance less likely. Our model can be a basis for testing differences in tax avoidance between different types of firms.

This is a preview of subscription content, log in to check access.

Fig. 1
Fig. 2
Fig. 3


  1. 1.

    Throughout the paper, the terms “tax avoidance” and “tax planning” are used synonymously to describe legal tax-planning activities.

  2. 2.

    In the following papers, the highest reported R-squared ranges from 9.4 to 14.9% for cash-effective tax rates: Armstrong et al. (2012), Badertscher et al. (2013), Chen et al. (2010), Cheng et al. (2012), Dyreng et al. (2008), Dyreng et al. (2010), Hope et al. (2013), Kubick et al. (2015), Rego (2003), Rego and Wilson (2012). Dyreng et al. (2010) obtained an R-squared of 23.6% when including various fixed effects.

  3. 3.

    Dyreng et al. (2019) provide an alternative explanation for this puzzle. They argue that firms can use their market power to pass on the tax burden to other stakeholders. In our model, we implicitly assume that the ability to pass on taxes to employees or consumers does not differ across firms. In contrast to Dyreng et al. (2019), we specifically consider agency issues.

  4. 4.

    Source: http://siteresources.worldbank.org/CGCSRLP/Resources/SME_statistics.pdf.

  5. 5.

    Source: http://www.ffi.org/page/globaldatapoints.

  6. 6.

    Since private firms have a higher success probability for aggressive tax planning activities, firms might have to pay higher wages to the tax manager. This effect occurs because tax managers are paid partially based on their success in tax planning e.g., (Armstrong et al. 2012). This effect may reduce the propensity of tax planning in private firms. However, it is unlikely that this effect dominates in our model.

  7. 7.

    Including penalties and detection risk would be possible in our model, for example, by including expected fines in the cost of tax avoidance.

  8. 8.


  9. 9.

    These are the consolidated after-tax earnings of the firm and all its subsidiaries. We do not model a certain group structure. Whenever, we speak about the “firm”, we imply that this is the entire consolidated group.

  10. 10.

    We acknowledge that we abstract from modeling different compensation packages, e.g., a combination of fixed pay and variable pay in our model. We leave this for future research.

  11. 11.

    Our model does not include an interest rate, because all parties’ final payoffs are realized at \(\tau =2\) or \(\tau =3\), respectively. We do not consider any interactions that occur thereafter.

  12. 12.

    The effort costs associated with tax planning include all costs that organizing and restructuring entail, such as networking, organizing majorities, and convincing others (see, e.g., Feller and Schanz 2017).

  13. 13.

    We model a continuum of private/public because firms can have publicly traded equity and/or debt. Put differently, there are firms who are not listed (fully private), firms with publicly traded debt but private equity, or firms for which both, debt and equity are traded (fully public). While this is actually stepwise, we simplify the model and use a continuous variable for listed. Similarly, we model family firms as a continuum following the approach in Astrachan et al. (2002).

  14. 14.

    Note that such managers will earn higher wages in our model consistent with the argument in Feller and Schanz (2017) that more powerful tax managers, i.e., the ones with higher success rates, earn higher wages.

  15. 15.

    Our model thus separates operational risk (\(q_1\)) and tax risk (\(p_1(s)\)) and assumes that these risks are not correlated. This is in line with the empirical observation that firms face different types of uncertainty (Stein and Stone 2013). For example, firms increase their cash holdings to use them as a buffer for tax uncertainty (Hanlon et al. 2016). While controlling for general firm risk (\(q_1\)), Jacob et al. (2019) show that tax uncertainty (\(p_1(s)\)) can delay large investments. In other words, firms face a tax risk (i.e., the risk of large unfavorable tax payments) in addition to general firm risk (Bauer and Klassen 2014).

  16. 16.

    Hence, we implicitly assume that there are no losses. Hence, firms cannot run into the problem of an asymmetric tax treatment of profits and losses.

  17. 17.

    Note that in a first-best setting, where effort choices are observable, the hierarchical structure does not play a role for the results. We therefore assume that the principal directly contracts with both agents.

  18. 18.

    See the “Appendix” for a formal proof of this statement.

  19. 19.

    The analysis of the second case can be done equivalently but does not substantially change the results in the sequential case.

  20. 20.

    Note that the principal’s expected payoff in this case is identical to the principal’s expected payoff in the simultaneous case (0, 1).

  21. 21.

    As we have argued in Sect. 5, the severity of the moral hazard problem can also be represented by the difference in probabilities, i.e., \(p_1(s)-p_0(s)\) and \(q_1-q_0\). However, to isolate the agent-level costs, we approximate costs of moral hazard by varying \(\kappa (s,m)\) and \(\gamma (s,m)\). The reason for doing so is twofold: first, probabilities may reflect further external influence (e.g., the success probabilities might also depend on the competitive environment of the firm). Second, since probabilities also play a role in our formal representation of, e.g., disclosure costs, their variation would simultaneously imply a change of agent-level and firm-level costs, which is undesirable when we want to discern effects.

  22. 22.

    The tax rates used in our example are close to the 25th percentile and the 75th percentile of the one-year cash-effective tax rate distribution from the sample of listed U.S. firms that Dyreng et al. (2008) use.

  23. 23.

    However, a higher success probability of aggressive tax planning does not only increase the probability for a smaller tax burden, it may also increase expected wage costs. This effect does, however, dominate the other forces so that the overall result is unambiguous.

  24. 24.

    Note that this also fulfills the tax manager’s participation constraint.


  1. Ang JS, Cole RA, Wuh Lin J (2000) Agency costs and ownership structure. J Financ 55(1):81–106

    Article  Google Scholar 

  2. Antonetti P, Anesa M (2017) Consumer reactions to corporate tax strategies. The role of political ideology. J Bus Res 74:1–10

    Article  Google Scholar 

  3. Armstrong CS, Blouin JL, Larcker DF (2012) The incentives for tax planning. J Acc Econ 53(1–2):391–411

    Article  Google Scholar 

  4. Astrachan JH, Klein SB, Smyrnios KX (2002) The F-PEC scale of family influence: a proposal for solving the family business definition problem. Fam Bus Rev 15(1):45–58

    Article  Google Scholar 

  5. Austin CR, Wilson R (2015) Are reputational costs a determinant of tax avoidance? SSRN Working Paper No. 2216879

  6. Badertscher BA, Katz SP, Pincus M, Rego SO (2009) Earnings management strategies and the trade-off between tax benefits and detection risk: to conform or not to conform? Account Rev 84(1):63–97

    Article  Google Scholar 

  7. Badertscher BA, Katz SP, Rego SO (2013) The separation of ownership and control and corporate tax avoidance. J Account Econ 56(2–3):228–250

    Article  Google Scholar 

  8. Bankman J (2004) An academic’s view of the tax shelter battle. In: Aaron HJ, Slemrod J (eds) The crisis in tax administration, 1st edn. Brookings Institution, Washington, pp 9–37

    Google Scholar 

  9. Bauer AM, Klassen KJ (2014) Estimating downside tax risk using large unfavorable tax payments. SSRN Working Paper No. 2379666

  10. Berle AA, Means GC (1932) The modern corporation and private property, 1st edn. Harcourt, Brace, & World, New York

    Google Scholar 

  11. Bozanic Z, Hoopes JL, Thornock JR, Williams BM (2017) IRS attention. J Account Res 55(1):79–114

    Article  Google Scholar 

  12. Chen K-P, Chu CCY (2005) Internal control versus external manipulation: a model of corporate income tax evasion. Rand J Econ 36(1):151–164

    Google Scholar 

  13. Chen S, Chen X, Cheng Q, Shevlin T (2010) Are family firms more tax aggressive than non-family firms? J Financ Econ 95(1):41–61

    Article  Google Scholar 

  14. Cheng CSA, Huang HH, Li Y, Stanfield J (2012) The effect of hedge fund activism on corporate tax avoidance. Account Rev 87(5):1493–1526

    Article  Google Scholar 

  15. Chrisman JJ, Chua JH, Litz RA (2004) Comparing the agency costs of family and non-family firms: conceptual issues and exploratory evidence. Entrep Theory Pract 28(4):335–354

    Article  Google Scholar 

  16. Chyz JA, Leung WSC, Li OZ, Rui OM (2013) Labor unions and tax aggressiveness. J Financ Econ 108:675–698

    Article  Google Scholar 

  17. Crocker KJ, Slemrod J (2005) Corporate tax evasion with agency costs. J Public Econ 89(9–10):1593–1610

    Article  Google Scholar 

  18. Desai MA, Dharmapala D (2006) Corporate tax avoidance and high-powered incentives. J Financ Econ 79(1):145–179

    Article  Google Scholar 

  19. Desai MA, Dharmapala D (2009a) Corporate tax avoidance and firm value. Rev Econ Stat 91(3):537–546

    Article  Google Scholar 

  20. Desai MA, Dharmapala D (2009b) Earnings management, corporate tax shelters, and book-tax alignment. Natl Tax J 62(1):169–186

    Article  Google Scholar 

  21. Dhaliwal DS, Gleason CA, Mills LF (2004) Last-chance earnings management: using the tax expense to meet analysts’ forecasts. Contemp Account Res 21(2):431–459

    Article  Google Scholar 

  22. Dyreng SD, Hanlon M, Maydew EL (2008) Long-run corporate tax avoidance. Account Rev 83(1):61–82

    Article  Google Scholar 

  23. Dyreng SD, Hanlon M, Maydew EL (2010) The effects of executives on corporate tax avoidance. Account Rev 85(4):1163–1189

    Article  Google Scholar 

  24. Dyreng SD, Hanlon M, Maydew EL (2014) Rolling the dice: When does tax avoidance result in tax uncertainty? SSRN Working Paper No. 2374945

  25. Dyreng SD, Hoopes JL, Wilde JH (2016) Public pressure and corporate tax behavior. J Account Res 54(1):147–186

    Article  Google Scholar 

  26. Dyreng SD, Jacob M, Jiang X, Müller MA (2019) Tax incidence and tax avoidance. SSRN Working Paper

  27. Dyreng SD, Lindsey BP (2009) Using financial accounting data to examine the effect of foreign operations located in tax havens and other countries on U.S. multinational firms’ tax rates. J Account Res 47(5):1283–1316

    Article  Google Scholar 

  28. Ernst & Young (2011) Tax risk and controversy survey: a new era of global risk and uncertainty, 1st ed, E & Y, New York

  29. Ewert R, Niemann R (2014) A theory of tax avoidance—managerial incentives for tax planning in a multi-task principal-agent model. CESifo Working Paper No. 4851

  30. Fama EF, Jensen MC (1983) Separation of ownership and control. J Law Econ 26(2):301–325

    Article  Google Scholar 

  31. Feller A, Schanz D (2017) The three hurdles of tax planning: how business context, aims of tax planning, and tax manager power affect tax. Contemp Account Res 34(1):494–524

    Article  Google Scholar 

  32. Fields TD, Lys TZ, Vincent L (2001) Empirical research on accounting choice. J Account Econ 31(1–3):255–307

    Article  Google Scholar 

  33. Francis J, Smith A (1995) Agency costs and innovation. Some empirical evidence. J Account Econ 19(2–3):383–409

    Article  Google Scholar 

  34. Gallemore J, Labro E (2015) The importance of the internal information environment for tax avoidance. J Account Econ 60:149–167

    Article  Google Scholar 

  35. Gallemore J, Maydew EL, Thornock JR (2014) The reputational costs of tax avoidance. Contemp Account Res 31(4):1103–1133

    Article  Google Scholar 

  36. Gómez-Mejía LR, Cruz C, Berrone P, De Castro J (2011) The bind that ties: socioemotional wealth preservation in family firms. Acad Manag Ann 5(1):653–707

    Article  Google Scholar 

  37. Gómez-Mejía LR, Takács Haynes K, Núñez Nickel M, Jacobson KJ, Moyano-Fuentes J (2007) Socioemotional wealth and business risks in family-controlled firms: evidence from Spanish olive oil mills. Adm Sci Q 52(1):106–137

    Article  Google Scholar 

  38. Graham JR, Hanlon M, Shevlin T, Schroff N (2014) Incentives for tax planning and avoidance: evidence from the field. Account Rev 89(3):991–1023

    Article  Google Scholar 

  39. Gupta S, Newberry K (1997) Determinants of the variability in corporate effective tax rates: evidence from longitudinal data. J Account Public Policy 16(1):1–34

    Article  Google Scholar 

  40. Han JC, Wang S-W (1998) Political costs and earnings management of oil companies during the 1990 Persian Gulf Crisis. Account Rev 73(1):103–117

    Google Scholar 

  41. Hanlon M, Heitzman S (2010) A review of tax research. J Account Econ 50(2–3):127–178

    Article  Google Scholar 

  42. Hanlon M, Maydew EL, Saavedra D (2016) The taxman cometh: Does tax uncertainty affect corporate cash holdings? SSRN Working Paper No. 2292020

  43. Hanlon M, Slemrod J (2009) What does tax aggressiveness signal? Evidence from stock price reactions to news about tax shelter involvement. J Public Econ 93(1–2):126–141

    Article  Google Scholar 

  44. Hardeck I, Hertl R (2014) Consumer reactions to corporate tax strategies. Effects on corporate reputation and purchasing behavior. J Bus Ethics 123(2):309–326

    Article  Google Scholar 

  45. Hope O-K, Ma MS, Thomas WB (2013) Tax avoidance and geographic earnings disclosure. J Account Econ 56(2–3):170–189

    Article  Google Scholar 

  46. Jacob M, Wentland K, Wentland SA (2019) Real effects of tax uncertainty: Evidence from firm capital investments. SSRN Working Paper No. 2518243

  47. Jensen MC, Meckling WH (1976) Theory of the firm: managerial behavior, agency costs and ownership structure. J Financ Econ 3(4):305–360

    Article  Google Scholar 

  48. Key KG (1997) Political cost incentives for earnings management in the cable television industry. J Account Econ 23(3):309–337

    Article  Google Scholar 

  49. Koester A, Shevlin TJ, Wangerin D (2016) The role of managerial ability in corporate tax avoidance. Manag Sci 63:3285–3310

    Article  Google Scholar 

  50. Kubick TR, Lynch DP, Mayberry MA, Omer TC (2015) Product market power and tax avoidance: market leaders, mimicking strategies, and stock returns. Account Rev 90(2):675–705

    Article  Google Scholar 

  51. Lee M-S, Rogoff E (1996) Comparison of small businesses with family participation versus small businesses without family participation: an investigation of differences in goals, attitudes, and family/business conflict. Fam Bus Rev 9:423–437

    Article  Google Scholar 

  52. Mills LF, Nutter SE, Schwab CM (2013) The effect of political sensitivity and bargaining power on taxes: evidence from federal contractors. Account Rev 88(3):977–1005

    Article  Google Scholar 

  53. Mills LF, Robinson LA, Sansing RC (2010) FIN 48 and tax compliance. Account Rev 85(5):1721–1742

    Article  Google Scholar 

  54. Ramanna K, Roychowdhury S (2010) Elections and discretionary accruals: evidence from 2004. J Account Res 48(2):445–475

    Article  Google Scholar 

  55. Rego S O (2003) Tax-avoidance activities of U.S. multinational corporations. Contemp Account Res 20(4):805–833

    Article  Google Scholar 

  56. Rego SO, Wilson R (2012) Equity risk incentives and corporate tax aggressiveness. J Account Res 50(3):775–810

    Article  Google Scholar 

  57. Richardson G, Lanis R (2007) Determinants of the variability in corporate effective tax rates and tax reform: evidence from Australia. J Account Public Policy 26(6):689–704

    Article  Google Scholar 

  58. Robinson JR, Sikes SA, Weaver CD (2010) Performance measurement of corporate tax departments. Account Rev 85(3):1035–1064

    Article  Google Scholar 

  59. Schmitz PW (2005) Allocating control in agency problems with limited liability and sequential hidden actions. RAND J Econ 36(2):318–336

    Google Scholar 

  60. Shackelford DA, Shevlin T (2001) Empirical tax research in accounting. J Account Econ 31(1–3):321–387

    Article  Google Scholar 

  61. Shleifer A, Vishny RW (1997) A survey of corporate governance. J Financ 52(2):737–783

    Article  Google Scholar 

  62. Slemrod J (2004) The economics of corporate tax selfishness. Natl Tax J 57(4):877–899

    Article  Google Scholar 

  63. Stein LC, Stone EC (2013) The effect of uncertainty on investment, hiring, and R&D: Causal evidence from equity options. SSRN Working Paper No. 1649108

  64. Villalonga B, Amit R (2006) How do family ownership, control and management affect firm value? J Financ Econ 80(2):385–417

    Article  Google Scholar 

  65. Watts RL, Zimmerman JL (1986) Positive accounting theory, 1st edn. Prentice Hall, Edgewood Cliffs

    Google Scholar 

  66. Watts RL, Zimmerman JL (1990) Positive accounting theory: a ten year perspective. Account Rev 65(1):131–156

    Google Scholar 

  67. Weisbach DA (2002) Ten truths about tax shelters. Tax Law Rev 55:2015–2053

    Google Scholar 

  68. Zimmerman JL (1983) Taxes and firm size. J Account Econ 5:119–149

    Article  Google Scholar 

Download references


We thank Ralf Ewert (the editor), two anonymous reviewers, Kay Blaufus, John Christensen, Markus Grottke (discussant), Jochen Hundsdoerfer, Daniela Lorenz, Maximilian Müller, Rainer Niemann, Martin Ruf, Harm Schütt, Caren Sureth, Antonio de Vito, participants of the EAA Annual Congress 2016 in Maastricht, the VHB Annual Congress 2016 in Munich, the 2014 GEABA conference in Regensburg, and seminar participants at the WHU - Otto Beisheim School of Management, the University of Bayreuth, and the University of Paderborn for helpful comments and suggestions. Anna Rohlfing-Bastian and Martin Jacob acknowledge financial support by the Deutsche Forschungsgemeinschaft (DFG, German Research Foundation)—Project-ID 403041268—TRR 266.

Author information



Corresponding author

Correspondence to Martin Jacob.

Additional information

Publisher's Note

Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.

Appendix A: Proofs

Appendix A: Proofs

Proof of Proposition 1

The principal’s payoff in the four possible scenarios of motivating tax planning and the generation of earnings is:

$$\begin{aligned} \Pi _{11}^{FB}&=p_1(s)\left[ (1-t_l)\left\{ q_1x^H+(1-q_1)x^L-\kappa (s,m)-\gamma (s,m)\right\} -\delta (s,t_l,m)\right] \\&\quad +[1-p_1(s)](1-t_h)\left\{ q_1x^H+(1-q_1)x^L-\kappa (s,m)-\gamma (s,m)\right\} -k,\\ \Pi _{01}^{FB}&=p_0(s)\left[ (1-t_l)\left\{ q_1x^H+(1-q_1)x^L-\kappa (s,m)\right\} -\delta (s,t_l,m)\right] \\&\quad +[1-p_0(s)](1-t_h)\left\{ q_1x^H+(1-q_1)x^L-\kappa (s,m)\right\} ,\\ \Pi _{10}^{FB}&=p_1(s)\left[ (1-t_l)\left\{ q_0x^H+(1-q_0)x^L-\gamma (s,m)\right\} -\delta (s,t_l,m)\right] \\&\quad +[1-p_1(s)](1-t_h)\left\{ q_0x^H+(1-q_0)x^L-\gamma (s,m)\right\} -k,\\ \Pi _{00}^{FB}&=p_0(s)\left[ (1-t_l)\left\{ q_0x^H+(1-q_0)x^L\right\} -\delta (s,t_l,m)\right] \\&\quad +[1-p_0(s)](1-t_h)\left\{ q_0x^H+(1-q_0)x^L\right\} . \end{aligned}$$

The difference \(\Pi _{11}^{FB}-\Pi _{01}^{FB}\) represents the principal’s payoff when high tax planning and high earnings generation are motivated less the principal’s payoff if only high earnings generation is motivated and can be used to obtain the condition under which tax planning is beneficial if the principal has motivated high earnings generation. Setting \(\Pi _{11}^{FB}-\Pi _{01}^{FB}>0\) and rearranging the terms yields the condition in Eq. (1a). We repeat the procedure for \(\Pi _{10}^{FB}-\Pi _{00}^{FB}>0\), i.e., the principal’s payoff with and without motivating high tax planning in case only normal effort is expended towards the generation of earnings to obtain the condition in Eq. (1b). \(\square\)

Proof of Lemma 1

We solve the model using backward induction. The tax manager at the lowest hierarchical level and thus the last stage of the game is willing to exert high effort for tax-planning activities if the following incentive compatibility constraint is met:

$$\begin{aligned} p_1(s)w(t_l)+[1-p_1(s)]w(t_h)-\gamma (s,m)\ge p_0(s)w(t_l)+[1-p_0(s)]w(t_h). \end{aligned}$$

Generally, if the CEO wants to implement low effort, she will choose to pay the lowest possible wage. Due to limited liability constraints, this is equal to zero.Footnote 24 Hence, the CEO will set \(w(t_h)=0\), which reduces the above incentive compatibility constraint to

$$\begin{aligned} p_1(s)w(t_l)-\gamma (s,m)\ge p_0(s)w(t_l). \end{aligned}$$

In equilibrium, the incentive compatibility constraint will be binding. Solving for the wage payment \(w(t_l)\) yields the optimal wage profile stated in connection with Lemma 1. \(\square\)

Proof of Lemma 2

The CEO is willing to exert high effort towards the generation of earnings if the following incentive compatibility constraint is fulfilled that depends on whether the tax manager is motivated to exert high effort (\(i=1\)) or not (\(i=0\)).

$$\begin{aligned} \begin{array}{ll} &{}q_1 \left( p_i(s)w(t_l,x^H)+[1-p_i(s)]w(t_h,x^H)\right) \\ &{}\qquad +(1-q_1)\left( p_i(s)w(t_lx^L)+[1-p_i(s)]w(t_h,x^L)\right) -\kappa (s,m)\\ &{}\quad \ge q_0\left( p_i(s)w(t_l,x^H)+[1-p_i(s)]w(t_h,x^H)\right) \\ &{}\qquad +(1-q_0)\left( p_i(s)w(t_l,x^L)+[1-p_i(s)]w(t_h,x^L)\right) , i=1,0. \end{array} \end{aligned}$$

Moreover, the principal needs to ensure that the CEO is willing to transfer the wage payment to the tax manager if the tax manager has been motivated to perform high effort and was successful in her tax planning activities. This is represented by the following constraints for either high earnings motivation (\(j=1\)) or low earnings motivation (\(j=0\)):

$$\begin{aligned} \begin{array}{ll} &{}p_1(s)\left( q_jw(t_l,x^H)+(1-q_j)w(t_l,x^L)-w(t_l)\right) \\ &{}\qquad +[1-p_1(s)]\left( q_jw(t_h,x^H)+(1-q_j)w(t_h,x^L)-w(t_h)\right) \\ &{}\quad \ge p_0(s)\left( q_jw(t_l,x^H)+(1-q_j)w(t_l,x^L)\right) \\ &{}\qquad +[1-p_0(s)]\left( q_j w(t_h,x^H)+(1-q_j)w(t_h,x^L)\right) , j=1,0. \end{array} \end{aligned}$$

The principal is not interested to pay anything to the CEO if earnings generation and tax planning have not been successful. As a consequence, she sets \(w(t_h,x^L)=0\). In connection with \(w(t_h)=0\), this reduces the incentive compatibility and contracting constraints for the CEO to the following expressions:

$$\begin{aligned} \begin{array}{ll} &{}q_1 \left( p_i(s)w(t_l,x^H)+[1-p_i(s)]w(t_h,x^H)\right) \\ &{}\qquad +(1-q_1)\left( p_i(s)w(t_l,x^L)\right) -\kappa (s,m)\\ &{}\quad \ge q_0\left( p_i(s)w(t_l,x^H)+[1-p_i(s)]w(t_h,x^H)\right) \\ &{}\qquad +(1-q_0)\left( p_i(s)w(t_l,x^L)\right) , i=1,0\end{array} \end{aligned}$$


$$\begin{aligned} \begin{array}{ll} &{}p_1(s)\left( q_jw(t_l,x^H)+(1-q_j)w(t_l,x^L)-w(t_l)\right) \\ &{}\qquad +[1-p_1(s)]\left( q_jw(t_h,x^H)\right) \\ &{}\quad \ge p_0(s)\left( q_jw(t_l,x^H)+(1-q_j)w(t_l,x^L)\right) \\ &{}\qquad +[1-p_0(s)]\left( q_j w(t_h,x^H)\right) , j=1,0. \end{array} \end{aligned}$$

Which of the four constraints binds, depends on the effort profile that the principal wants to implement. Solving the respective system of equations for the possible scenarios yields the wage profile for the CEO as stated in Lemma 2. \(\square\)

Proof of Proposition 2

The principal’s payoff in the second-best case with simultaneous effort choices is:

$$\begin{aligned} \Pi _{11}&=p_1(s)\left[ (1-t_l)\left\{ q_1(x^H-w(t_l,x^H))+(1-q_1)(x^L-w(t_l,x^L))\right\} \right. \left. -\delta (s,t_l,m)\right] \\&\quad +[1-p_1(s)](1-t_h)\left\{ q_1(x^H-w(t_h,x^H))+(1-q_1)(x^L-w(t_h,x^L))\right\} -k, \\ \Pi _{10}&=p_1(s)\left[ (1-t_l)\left\{ q_0(x^H-w(t_l,x^L))+(1-q_0)(x^L-w(t_l,x^L))\right\} \right. \left. -\delta (s,t_l,m)\right] \\&\quad +[1-p_1(s)](1-t_h)\left\{ q_0(x^H-w(t_h,x^L))+(1-q_0)(x^L-w(t_h,x^L))\right\} -k,\\ \Pi _{01}&=p_0(s)\left[ (1-t_l)\left\{ q_1(x^H-w(t_h,x^H))+(1-q_1)(x^L-w(t_h,x^L))\right\} \right. \left. -\delta (s,t_l,m)\right] \\&\quad +[1-p_0(s)](1-t_h)\left\{ q_1(x^H-w(t_h,x^H))+(1-q_1)(x^L-w(t_h,x^L))\right\} , \\ \Pi _{00}&=p_0(s)\left[ (1-t_l)\left\{ q_0(x^H-w(t_h,x^L))+(1-q_0)(x^L-w(t_h,x^L))\right\} \right. \left. -\delta (s,t_l,m)\right] \\&\quad +[1-p_0(s)](1-t_h)\left\{ q_0(x^H-w(t_h,x^L))+(1-q_0)(x^L-w(t_h,x^L))\right\} . \end{aligned}$$

Inserting the optimal wage profiles for the tax manager and the CEO from Lemmas 1 and 2 yields the principal’s expected payoff in the four settings:

$$\begin{aligned} \Pi _{11}^\dagger&=\left[ p_1(s)(1-t_l)+\left[{1-p_1(s)}\right](1-t_h)\right] \left( q_1x^H+(1-q_1)x^L-\frac{q_1\kappa (s,m)}{q_1-q_0}\right) \\&\quad -p_1(s)\left( \delta (s,t_l,m)+(1-t_l)\frac{p_1(s)\gamma (s,m)}{[p_1(s)-p_0(s)]^2}\right) -k,\\ \Pi _{10}^\dagger&=\left[ p_1(s)(1-t_l)+\left[{1-p_1(s)}\right](1-t_h)\right] \left( q_0x^H+(1-q_0)x^L\right) \\&\quad -p_1(s)\left( \delta (s,t_l,m)+(1-t_l)\frac{p_1(s)\gamma (s,m)}{[p_1(s)-p_0(s)]^2}\right) -k,\\ \Pi _{01}^\dagger&=\left[ p_0(s)(1-t_l)+\left[{1-p_0(s)}\right](1-t_h)\right] \left( q_1x^H+(1-q_1)x^L-\frac{q_1\kappa (s,m)}{q_1-q_0}\right) \\&\quad -p_1(s)\delta (s,t_l,m),\\ \Pi _{00}^\dagger&=\left[ p_0(s)(1-t_l)+\left[{1-p_0(s)}\right](1-t_h)\right] \left( q_0x^H+(1-q_0)x^L\right) -p_0(s)\delta (s,t_l,m). \end{aligned}$$

Subtracting \(\Pi _{10}^\dagger\) from \(\Pi _{11}^\dagger\) and subtracting \(\Pi _{00}^\dagger\) from \(\Pi _{01}^\dagger\) and rearranging the terms gives the conditions (2a) and (2b) in Proposition 2. \(\square\)

Proof of Lemma 3

In a sequential setting, the incentive constraint for the tax manager at the last stage of the game does not change and is the same as presented in connection with Lemma 1. The CEO is willing to perform high effort on earnings given the success-dependent following motivation of the tax manager, if the following constraint is fulfilled:

$$\begin{aligned} \begin{array}{ll} &{}q_1\left( p_1(s)[w(t_l,x^H)-w(t_l)]+[1-p_1(s)]w(t_h,x^H)\right) +(1-q_1)w(t_h,x^L)-k\\ &{}\quad \ge q_0\left( p_1(s)[w(t_l,x^H)-w(t_l)]+[1-p_1(s)]w(t_h,x^H)\right) +(1-q_0)w(t_h,x^L). \end{array} \end{aligned}$$

Moreover, the CEO is willing to transfer the wage to the tax manager, if the following constraint is fulfilled:

$$\begin{aligned}&p_1(s)[w(t_l,x^H)-w(t_l)]+[1-p_1(s)]w(t_h,x^H)\\&\quad \ge p_0(s)w(t_l,x^H)+[1-p_0(s)]w(t_h,x^L). \end{aligned}$$

Note that the moral hazard problem with respect to the contracting decision of the CEO only occurs in case of successful generation of high earnings. Hence, besides the wage \(w(t_h,x^L\)), the principal also sets the wage \(w(t_l,x^L)\) equal to zero, because she does not want the CEO to motivate the tax manager to perform high effort if earnings were low. In equilibrium, both constraints are binding and solving the respective system of equations gives the wage profile of the CEO stated in connection with Lemma 3. \(\square\)

Proof of Proposition 3

The principal’s payoff in the second-best case with sequential effort choices when high earnings generation effort is motivated and tax planning only if earnings generation has been successful, is given by:

$$\begin{aligned} \Pi _{101}^\dagger&=q_1\left[ p_1(s)\left\{ (1-t_l)\left( x^H-\frac{\kappa (s,m)}{q_1-q_0}-[1-p_0(s)]\frac{p_1\gamma (s,m)}{[p_1(s)-p_0(s)]^2}\right) \right. \right. \left. \left. -\delta (s,t_l,m)\right\} \right. \\&\quad \left. +[1-p_1(s)](1-t_h)\left( x^H-\frac{\kappa (s,m)}{q_1-q_0}+p_0(s)\frac{p_1(s)\gamma (s,m)}{[p_1(s)-p_0(s)]^2}\right) -k\right] \\&\quad +(1-q_1)\left( p_0(s)\left[ (1-t_l)x^L-\delta (s,t_l,m)\right] +[1-p_0(s)](1-t_h)x^L\right) . \end{aligned}$$

The respective reference case to compare with would be a case in which high earnings generation effort is motivated, but no tax planning. In this case, the contracting constraints do not bind and the CEO is paid a positive wage equal to \(w^{CEO}=\displaystyle \frac{\kappa (s,m)}{q_1-q_0}\) if high earnings are realized. The corresponding principal’s payoff is:

$$\begin{aligned} \Pi _{001}^\dagger&=q_1\left[ p_0(s)\left\{ (1-t_l)\left( x^H-\frac{\kappa (s,m)}{q_1-q_0}\right) -\delta (s,t_l,m)\right\} \right. \\&\quad \left. +[1-p_0(s)](1-t_h)\left( x^H-\frac{\kappa (s,m)}{q_1-q_0}\right) \right] \\&\quad +(1-q_1)\left[ p_0(s)\left\{ (1-t_l)x^L-\delta (s,t_l,m)\right\} +[1-p_0(s)](1-t_h)x^L\right] . \end{aligned}$$

Subtracting \(\Pi _{001}^\dagger\) from \(\Pi _{101}^\dagger\) and rearranging the terms gives the condition presented in connection with Proposition 3. \(\square\)

Proof of the Non-Optimality of Case \((0(x^H),1(x^L),1)\)

In Sect. 5.2 we analyze the sequential setting with the decision rule that high tax planning effort should be motivated if the earnings outcome was good. One could also think of the alternative decisions rule, i.e., that high tax planning effort should be motivated if the earnings outcome was bad, resulting in a case with the effort profile \((0(x^H),1(x^L),1)\). We now demonstrate that this case can never be optimal from the principal’s perspective. The wage profile offered to the CEO in this case would be

$$\begin{aligned} w^{CEO}=\left\{ 0,\frac{p_1(s)\gamma (s,m)}{[p_1(s)-p_0(s)]^2},\frac{p_1(s)p_0(s)\gamma (s,m)}{[p_1(s)-p_0(s)]^2}+\frac{\kappa (s,m)}{q_1-q_0},0\right\} \end{aligned}$$

and the resulting principal’s payoff is

$$\begin{aligned} \begin{array}{ll} \Pi _{011} & = q_1\left( p_0(s)\left( [t_h-t_l]x^H-\displaystyle\frac{\kappa (s,m)}{q_1-q_0}+\{(1-t_h)-p_0(s)[t_h-t_l]\}\displaystyle\frac{p_1(s)\gamma (s,m)}{[p_1(s)-p_0(s)]^2}\right. \right. \\ &\left. \left. \quad -\delta (s,t_l,m)\right) \right. \\ &\quad +\left. (1-t_h)(x^H-\displaystyle\frac{\kappa (s,m)}{q_1-q_0})\right) \\ &\quad +(1-q_1)\left( p_1\left( [t_h-t_l]x^L-(1-t_l)\displaystyle\frac{p_1(s)\gamma (s,m)}{[p_1(s)-p_0(s)]^2}-\delta (s,t_l,m)\right) \right. \\ &\quad \left. +(1-t_h)x^L-k\right) . \end{array} \end{aligned}$$

The general decision whether to engage in effort motivation for tax planning depends on the benefits and costs. In a situation where incentivization costs are low, the principal prefers simultaneous decisions and high effort motivation in both tasks (case (1,1)). When incentivization costs rise, the principal will switch to a sequential setting in which he motivates tax planning only for successful earnings generation (case \((1(x^H),0(x^L),1)\)) as this provides a higher positive impact on the principal’s payoff through the tax-base effect (the total benefits of tax planning are given by the reduced tax rate multiplied with earnings). When incentivization costs rise further, the principal switches to a simultaneous setting where he never motivates tax planning, but only earnings generation (case (0,1)). Hence, the border between the cases \((1(x^H),0(x^L),1)\) and (0,1) could be the only region where the above mentioned case \((0(x^H),1(x^L),1)\) could be theoretically optimal. The border between the region where the simultaneous case (0,1) becomes better than the sequential case \((1(x^H),0(x^L),1)\) is given by

$$\begin{aligned} \Delta _1=\Pi _{101}-\Pi _{01}. \end{aligned}$$

From the inequality \(\Delta _1<0\), conditions for the parameters \(\kappa (\cdot )\), \(\gamma (\cdot )\), \(\delta (\cdot )\) and k can be derived for which the simultaneous case dominates the sequential setting. Applying these conditions to the comparison

$$\begin{aligned} \Delta _2=\Pi _{011}-\Pi _{01} \end{aligned}$$

shows that the case \((0(x^H),1(x^L),1)\) can never be better than the simultaneous case (0,1) under conditions where this simultaneous case is better than the sequential case \((1(x^H),0(x^L),1)\), i.e., \(\Delta _2<0\) for the conditions derived from \(\Delta _1<0\). In this scenario, incentivization costs for tax planning are such that the principal would never motivate tax planning at all. \(\square\)

Rights and permissions

Reprints and Permissions

About this article

Verify currency and authenticity via CrossMark

Cite this article

Jacob, M., Rohlfing-Bastian, A. & Sandner, K. Why do not all firms engage in tax avoidance?. Rev Manag Sci (2019). https://doi.org/10.1007/s11846-019-00346-3

Download citation


  • Moral hazard
  • Tax avoidance
  • Tax planning

JEL Classification

  • D21
  • H26
  • H32