The relation between firm size and effective tax rates: A test of firms' political success.

Abstract Prior research has investigated firms' success in the political process and its relation to firm size. For example, effective tax rates have been used to measure the extent to which firms are able to influence cor- porate income taxation. Effective tax rates, however, are a biased proxy of political success because they may contain a factor, net operating losses (NOLs), attributable to firms' operating results and experience rather than to success in the political process. Moreover, if firm size is also correlated with NOLs, then NOL,s may affect the relationship between firm size and tax rates in a systematic manner. If such an effect is substantial, the association of firm size and effective tax rates will be a biased basis for drawing inferences about firm size and political success. The purpose of this article is to assess the extent of the effect of NOLs on the overall relationship of firm size and tax rates. Path analysis is employed to isolate the effect of firm size on effective tax rates that is attributable to NOLs (i.e., the indirect effect of NOLs). Determining the indirect effect of NOLs allows an assessment of the bias in the overall firm size/tax rate relation attributable to NOLs. To estimate the indirect effect of NOLs, a path model with two structural equations is built to identify the indirect links between firm size and effective tax rates mediated by NOLs, and the remaining direct link between firm size and effective tax rates. To correct errors-in-variables problems and to provide a consistent interpretation of the results, variables in the structural equations are modeled by a latent-variable approach (measurement model). The path model and the measurement model are estimated by LISREL Based on the parameter estimates of the structural equations, the path analysis results indicate that the indirect effect of NOLs has a statistically significant impact on the overall relationship between firm size and effective tax rates. This indicates that NOLs constitute an importarnt omitted variable in prior studies. While effective tax rates may measure some degree of firms' success in the political process, conclusions regarding the relation between firm size and firms' success In the political. process is confounded by the serious omission of NOLs.