MANUAL DE PROCEDIMIENTOS OPERATIVOS ESTANDARIZADOS

5.5.1 Hold-out Sample Prediction

It has been argued that it is better to use OLS model for prediction, therefore, to validate our results, we apply an out-sample test where we estimate ABTD in a different sample to the test period. Both Tang & Firth's (2011) model and our BTD model with the sample period from 2006 to 2012 are applied. In particular,we use the parameters estimate in the subsample 1 (samples are divided into two subsamples bases on the number of listed firms involved, subsample1 is the first half of total number of listed firms and the remaining is the subsample 2)to calculate the NBTDs for the subsample 2 and obtain the predicted ABTDs (predicted residuals). Then subsample 2 is estimated with the same BTD model variables to obtain the actual ABTDs (actual residuals). Finally, to calculate the sum of squares the distance between the predicted ABTDs using hold-out sample tests and actual ABTDs derived from

-1.50E-02 -1.00E-02 -5.00E-03 0.00E+00 5.00E-03 1.00E-02 1.50E-02 2006 2007 2008 2009 2010 2011 2012 tax shelt er in g r esid u als

Figure 5.1: The evolution of tax

aggressiveness residuals from 2006 to 2012

average sheltering

plus one standard deviation minus one standard deviation

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subsample 2, with our BTD model and Tang & Firth's model. It is worth noting that in our BTD model, the dependent variable is total permanent BTDs, while in Tang & Firth's (2011) model, the dependent variable is total BTDs, for comparison purpose, both total BTDs and permanent BTDs as dependent variable in Tang & Firth's (2011) model is applied. As we can see from the Table 5.6, our model has a smaller sum of squares between predicted ABTDs and actual ABTDs, which indicate our BTD model is more accurate in measuring the level of tax aggressiveness.

Table 5. 6: Sum of Squares between predicted ABTDs and actual ABTDs

Sum of squares

Tang & Firth's (2011) model with total BTDs 0.007408921 Tang & Firth's (2011) model with total permanent BTDs 0.000872256

Our BTDs model 0.0000507

5.5.2 The explanatory power of tax management and earning management

The raw BTD is not a pure measure of tax avoidance, with the residual approach applied in BTDs model, the ABTDs can be argued to be a function of earning management and tax avoidance. Following the approach of Tang & Firth (2011), weestimate the relationship between absolute ABTDs derived from our BTDs model and the incentives for earning management (EM) and tax management (TM) using set of variables that are proxy for various EM and TM incentives from Tang & Firth (2011)'s model. TM incentives variable is ATR is the applicable tax rate for the sample listed firms disclosed in the tax notes, EM incentives variables include SEON which is a dummy variable that equals to 1 when consolidated entity has a rights issue or public offering in year t+1 and 0 otherwise, and LOSS which is also a dummy variable that equals to 1 when a consolidated entity has a loss in the current year t and 0 otherwise. TM and EM variable is the SOELG which is a dummy variable that

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equals to 1 when a consolidated entity is a state-owned enterprise controlled by a central or local government and 0 otherwise.

Table 5.7 represents the extent to which different factors affect ABTDs derived from our BTDs model. The results from the four models indicate that EM account for 0.76 percent of ABTDs, TM explain 1.6 percent of ABTDs, and the combined EM and TM incentives explain 2.26 percent of ABTDs. The results are consistent with tax and non-tax cost literature review that TM and EM are dependent and interactive (Tang & Firth, 2011), and suggest that ABTDs account more for tax sheltering activities than earning management, as a result, in the next two chapter, EM variable will be included in regression to control for effects of earning management.

Table 5. 7: The explanatory power of earning management and tax management

Factors Model Adjusted R2

EM factors (SOEN,LOSS) ABTD=α0+ΣEM+ε 0.76%

TM factors (ATR) ABTD=α0+ΣTM+ε 1.6%

Combined TM/EM factors (SOELEG) ABTD=α0+ΣTM/EM+ε 2.26% EM, TM and EM/TM factors ABTD=α0+ Σ EM+ Σ TM+ Σ

TM/EM+ε

4.68%

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5.6 Shareholders' valuation of corporate tax planning

Tax planning activities is of significance to both shareholders and firms. Traditionally, shareholders would like to minimize corporate tax payments net of costs in order to achieve firm value maximization, in other words, shareholders wants firms to be optimally aggressive in their tax reporting to benefit themselves. However, the underlying motivation has been questioned. It is argued by Desai & Dharmapala (2006) that a form of agency costs, for example, an information asymmetry between shareholders and managers in terms of corporate tax sheltering activities, can facilitate managers acting for their own interests resulting a negative relationship between tax aggressiveness and firm value; and a positive relationship between book-tax differences and Tobin's Q is found only for well-governed firms in Desai & Dharmapala (2009). Prior studies examining the association between the measure of tax aggressiveness and stock performance of firms provide evidences consistent with a negative relationship between tax aggressiveness and future firm performance (Lev& Nissim, 2004; Hanlon, 2005; Wahab & Holland, 2012). In contrast,some studies find no direct association between related measure of tax aggressiveness and measures of firm value; this may be due to the effect of unquantifiable non-tax costs (Cloyd, Mills & Weaver, 2003).

The empirical studies suggest that on average there is negative valuation implication of tax aggressiveness. In this section, we look for the association between ABTDs and several measure of firm value in Chinese context, in order to study shareholders' valuation of tax aggressiveness. This study contributes to the growing book-tax differences literature, including the branch that examines the shareholder value of tax planning activities. Meanwhile, we will examine whether the valuation effects of tax aggressiveness depending on firms' ex ante strength of corporate governance, following the studies of Desai & Dharmapala (2009) and Wahab & Holland (2012). The finding can have direct policy implications for shareholders and tax authorities in monitoring