Exploring the Impact of Firm‐level Legality on Tax Avoidance

• DOI: http://doi.org/10.1111/emre.12382
• Published date: 01 June 2020
• Date: 01 June 2020

Exploring the Impact of Firm-level Legality on

Tax Avoidance

GIANLUCA GINESTI,

1

LUCA VINCENZO BALLESTRA

2

and RICCARDO MACCHIONI

3

1

Departmentof Management,Economics, Institutions - Universityof Naples “Federico II”, Monte S. AngeloUniversity Campus,

Naples, Italy

2

Department of Statistical Sciences "Paolo Fortunati", Alma Mater Studiorum University of Bologna, Via delle Belle Arti 41,

Bologna, Italy

3

Department of Economics, University of Campania “Luigi Vanvitelli”,Italy

Although the topic of legality is receiving increasing interest in academic and policy debates, examining its

economic effects at the firm level remains a relatively underexplored line of research. This study offers further

advances to the existing literature by performing an examination of the relationship between corporate legality

and tax avoidance.Based on a unique dataset of 1,168 private Italian companies and by exploiting a novel measure

of corporate legality developed by the Italian Competition Authority, we provide evidence that firm-level legality is

positively associated with effective tax rates ..(i.e., lower tax avoidance practices). These findings are robust to a

battery of additional tests and are informative for local policymakers and international investors since they suggest

that legality is an important factor to which attention should be paid in scrutinizing corporate tax strategies.

Keywords: Corporate legality; Legality rating; Ethical values; Effective tax rate; Tax avoidance

Introduction

The topic of corpor ate tax avoidance is receiving

increasing interest in different streams of literature

because of its relevant implications for policy and society

(Hanlon and Heitzman, 2010; Huseynov and Klamm,

2012). While academic studies have investigated the

determinants of corporate legality (McKendall and

Wagner, 1997; Werner et al., 2018), little is known about

the impact of firm-level legality on tax avoidance. In

particular, a firm-level examination of legality remains a

relatively underexplored area of research (de Jong and

van Ees, 2014),and the extant literature has notsucceeded

in finding a well-accepted measure of legality (Treisman,

2007). This is probably because exploring the legality at

the firm level is a multifaceted phenomenon (Luo, 2005;

Cosenz and Noto,2014; Lopatta et al., 2017) that includes

several aspects, such as bribery, fraud, ethics, anti-trust

violations, omissions made by mangers and many others

(Song and Han, 2017).

Given that corporate tax avoidance is a complex issue

to investigate, researchers have focused their attention on

its indirectmeasures, such as the effectivetax rates (ETRs)

(Dyreng et al., 2010, 2017). Despite some inherent

limitations of ETRs, these measures are considered to be

summary statistics that capture the overall effect of tax

incentives and actions aimed at reducing the amount of

tax expenses relative to the statutory tax rate (Gupta and

Newberry, 1997; Dyreng et al., 2010; Tang, 2019). Hence,

in this study we do not attemptto measure tax evasion but

following prior research we use ETR measures as proxies

of tax avoidance because it is plausible that companies

with lower ETRs engage in more aggressive tax

avoidance strategies. However, corporate tax avoidance,

even if it is in perfect compliance with the law (Landolf,

2006; West, 2018), produces economic effects that are

similar to tax evasion, albeit they are perceivedas socially

different (Kirchler et al., 2003).

The present studygoes beyond the existing literatureby

testing the impact of corporate legality on the variation of

ETR values among companies. In this respect, we believe

that an empiricalinvestigation of the relationshipbetween

corporate legality and tax avoidance is important for

several reasons. First, as some scholars have argued,

firms’tax strategies are influenced by their specific

Correspondence: Gianluca Ginesti, Department of Management,

Economics, Institutions - University of Naples “Federico II”, Monte S.

Angelo University Campus, Naples (Italy). E-mail gianluca.

ginesti@unina.it

European Management Review, Vol. 17, 499–514, (2020)

DOI: 10.1111/emre.12382

©2020 European Academy of Management

attitude towards ethics and legality (Lanis and

Richardson, 2012, 2015; Payne and Raiborn, 2018).

Moreover,scholars stress the importanceof understanding

whether and how the legality dimension affects tax

avoidance behaviours (Blaufus et al., 2016). Finally,

recent research supports the argument that investigating

the legality component of corporate social responsibility

(CSR) is essential to understand effectively the firm’s

behaviours (Dawson et al., 2019).

The focus on the Italian setting is well-suited for this

kind of analysis because the theme of business legality

in Italy is perceived, by both academics and international

organizations, as an important public concern that

prevents the growth of economic activities (Acconcia

et al., 2014; Ravenda et al., 2015; Transparency

International, 2017; Ganau and Rodríguez-Pose, 2018).

Moreover, the dataset we use has the advantage of being

composed of privateand small firms,

1

which are generally

less exposed to regulatory interventions than large and

publicly traded companies, especially as far as legality

and tax issues are concerned (Fisman and Svensson,

2007).

To measure corporate legality, we exploited a unique

dataset containing information on 1,168 Italian private

companies that have obtained the official ‘legality rating’

released by the Italian Competition Authority (ICA).

Unlike other legality indexes (for a complete review, see

Treisman,2007), which are based on opinions orsurveys,

the ‘legality rating’provides a comprehensive measure of

corporate legality. Thus, the use of this measure extends

previous knowledge and provides an original assessment

of the implications of corporate legality in Italy.

The results of our empirical analysis indicate that

corporate legality is positively associated with ETRs,

which suggests that firms having a higher degree of

legality moderate the tension toward tax avoidance

practices. These findings are robust to endogeneity tests,

to a variety of alternative regression model specifications,

as well as to a changein the time period over which ETRs

are measured.

By empirically investigating the relationship between

legality and tax avoidance, this study contributes to the

literature on the economic consequences of corporate

legality (Baucus and Baucu s, 1997; Mishina et al.,

2010), that could be also useful in understanding the

perspective of CSR actions and corporate culture (Laguir

et al., 2015; Whait et al., 2018). In doing so, we also

extend a recent study by Ma and Thomas (2019), who

investigate the impact of legality on tax avoidance by

using a country-level perspective, and we contribute to

addressing theissue of measuring legality at thefirm level

(Lopatta et al., 2017).

This study may have practical implications since it

suggests that promoting business legality with a soft law

approach (Bird and Davis-Nozemack, 2018) may prompt

managerial actions less costly for society. Moreover, we

believe that an external evaluation of corporate legality

could be useful for capital providers as a screening tool

to differentiate among companies (e.g. having higher vs

lower rating ranks) when they decide to invest in private

companies thatoperate in a domestic market.Collectively,

understanding the extent to which a local company

incorporates the ethic of legality avoid hazards or costs

related to illegal corporate practices that international

investors may incur in the long term.

The remainderof the paper is organized asfollows. The

following section reviews the literature and presents our

hypotheses. The third section illustrates the methodology

and provides a description of the data sample, the

variables and the regressions employed. The fourth

section reports the results of the baseline regression

analysis and the fifth section provides a set of robustness

tests. The final section discusses the main implications

of this study and concludes the paper.

Literature review and hypotheses

Managers try to optimize their company’s tax payments

by engaging in several tax strategies, which can be either

legal or illegal, andresearchers do not always use broadly

accepted terms and parameters to analyse the effects of

these policies (Guenter et al., 2013).

Even if both tax evasion and tax avoidance aim to

reduce taxable income, these two strategies are different

in term of legality and ethical sensitivity (Whait et al.,

2018). In general, tax evasion is viewed as an illegal and

unethical behaviour because it consists of dishonest

violations of tax laws to pursue a reduction in tax

liabilities, whereas tax avoidance is considered a legal,

albeit not socially responsible, behaviour thataims to take

advantage of legitimate opportunities given by law to

reduce taxable income (Payne and Raiborn, 2018).

Moreover, as suggested by Payne and Raiborn (2018),

we can also refer to a concept of ‘aggressive tax

avoidance’, which is an unethical approach explo iting

the existence of ambiguous legal interpretations or legal

‘loopholes’to reduce tax payments. In summary, the

concept of tax avoidanceis a continuum, which goes from

totally legalstrategies to more aggressiveones. Therefore,

tax avoidanceis not easy to define, and previous empirical

research indirectly measures ‘tax avoidance’by using

ETR metrics (see Hanlon and Heitzman (2010) for a

complete review).

Studies in tax literature show evidence of the existence

of various firm-level factors related to corporate tax

avoidance, including firm size, profitability, leverage,

1

The median valuefor the number of a firm’s employees is 32.

500 G. Ginesti et al.

©2020 European Academy of Management