International Journal of Business, Accounting and Management

ISSN : 2527-3531 | Volume 3, Issue 1(March) 2018

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The Determinants And Economic Consequences Of Tax Avoidance In Indonesia: The Effects Of Top
Management Characteristics And Capital Structure

Stevanus Pangestu1, Irenius Dwinanto Bimo2

1
Atma Jaya Catholic University of Indonesia Jakarta, Indonesia
Email correspondence: pangestu@atmajaya.ac.id
2
Atma Jaya Catholic University of Indonesia Jakarta, Indonesia
Email correspondence: idbimo@yahoo.com

Abstract : Tax avoidance is the lawful minimization of income tax by employing legal methods. This study aims to
assess the effects of top management characteristics and capital structure on tax avoidance, measured with
Effective Tax Rate (ETR). Our longitudinal dataset of publicly listed Indonesian manufacturing corporations over
the period of 2010-2015 produces 452 firm-year observations. Based on our statistical analysis using random
effects regression model on the EViews software, we find that tax avoidance: (i) is negatively influenced by
independent directors (ii) is positively affected by foreign directors; (iii) is influenced by capital structure,
measured with firm leverage, and (iv) positively affects current profitability, measured with Return on Equity.
Whereas the effects of female directors are found to be nonexistent. We also offer empirical evidence that
characteristics of board of directors influence tax avoidance through financing decisions. The findings of this study
suggest that firm capital structure determination is motivated by the intention to avoid taxes.

Keywords: Tax avoidance, board characteristics, capital structure, corporate governance

INTRODUCTION
On 8November 2016, Donald Trump was elected as the 45th President of the United States and he accomplished this
without disclosing his tax returns; breaking the 40-year norm of presidential nominees releasing these documents.
This phenomenon, along with the $916 million loss declaration on his 1995 tax returns, insinuates his decades of tax
avoidance. S&P Global Market Intelligence revealed that many of the 500 largest American companies avoided
federal income taxes, e.g. Facebook, Boeing, Google, Apple, and Coca-Cola. Between 2007 and 2015, S&P 500
companies paid an average of 26.9% in income taxes when the official rate was 35%.

The motivations for avoiding taxes have been recognized. Lim (2011) showed that tax avoidance
significantly reduces cost of debt. Richardson, Taylor, and Lanis (2015) documented positive association between
financial distress and corporate tax avoidance, signifying that there would be higher incentives to avoid tax during
times of financial crisis. Chaudhry, Yong, and Veld (2016) found that firms would engage more in tax avoidance
when there was a decline in the funding status of pension plans. These empirical findings indicate that tax
avoidance could benefit companies and the action to do so is decided by the top management or board of directors
(BOD). Conversely, the risks of avoiding taxes have also been established. Hasan, Hoi, Wu, and Zhang (2014)
showed that banks (creditors) perceived tax avoidance as the cause of significant risks. This could inhibit firms from
obtaining loans. Badertscher, Katz, and Rego (2013) categorized corporate tax avoidance as a risky activity that
could impose significant costs on a firm. Albeit the risks such decision possesses, Taylor and Richardson (2014)
indicated that remuneration incentives of management personnel are positively associated with tax avoidance. This
explains that shareholders do not punish their upper management for avoiding taxes because it could potentially
increase after-tax earnings, and consequently, the firm value.

Tax-avoidance engagements could also be affected by the firm’s capital structure. The government of
Indonesia attempts to mitigate the probability of corporate tax avoidance through the introduction of the Ministerial
Decree of Finance 169/PMK.010/2015 in 2015, concerning the Determination of the Comparison between
Liabilities and Capital of Company for the Calculation of Income Tax. A firm could opt to finance its assets through

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 The Determinants And Economic Consequences Of Tax Avoidance In Indonesia: The
Effects Of Top Management Characteristics And Capital Structure

debt or equity securities. Pecking Order theory states its preference toward internal funding. However, if a firm
needs finance externally, then debt financing would be selected due to its lower cost of capital, compared to its
equity counterpart. The interest expense arising from debt securities such as bond would create tax benefit for the
company.

When a firm avoids paying cash taxes, it would not only save firm assets, but also preserve the firm’s
profit. Despite the permissible nature of tax avoidance, negative consequences could also occur. For example, Chen,
Hu, Wang, and Tang (2014) found that tax avoidance behavior increased agency costs and decreased firm value.
The strategic measure that was accomplished for long-term shareholder value turned out to be disadvantageous for
the company.

Earlier studies about the effects of BOD characteristics and capital structure have also been done before
(Tarus and Ayabei, 2016; Faccio et al., 2016), as well as the influence of tax avoidance on firm performance
(Chasbiandani and Martani, 2012). This research differs from others by expanding previous investigations
(Chasbiandani and Martani, 2012): we explore how board characteristics affect tax avoidance through capital
structure.

Based on our research introduction and the rareness in literature, we would like to assess (i) whether BOD
characteristics influence capital structure and tax avoidance in Indonesian companies, (ii) how firm capital structure
affects tax avoidance, and (iii) how tax avoidance influences firm performance, measured with profitability.

Figure 1. Research Model

LITERATURE REVIEW & HYPOTHESIS DEVELOPMENT

Board of Directors and Tax Avoidance

Desai and Dharmapala (2005) developed a concept to comprehend how management affects tax avoidance.
Armstrong, Blouin, Jagolinzer, and Larcker (2015) suggested that agency problems might lead managers to engage
in corporate tax avoidance. This indicates that the decision to avoid taxes has to come from the BOD itself; they are
in full control of taking such action.

Studies of gender factor in tax avoidance literature are still scarce compared to earnings management or
firm performance literatures. Earlier investigations show contradictory results. Some have found that women tend
to: (i) supervise or control more effectively, (ii) increase firm value, (iii) be more conservative, and (iv) be more
law-abiding. (Gavious at al., 2012; Gulamhussen and Santa, 2015). Rose (2007), however, showed that there was no
relationship between gender and firm performance. Whereas Adams and Ferreira (2009) found a negative
relationship between female directors and firm performance. Conceptually, women are considered different from
men in terms of ethics, motivations, achievements, and social stereotypes (Gavious et al., 2012). We therefore
predict that boards consisting of female members would be more risk-averse and not engage in tax avoidance, which
has high political costs.

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 The Determinants And Economic Consequences Of Tax Avoidance In Indonesia: The
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H1: Female directors negatively influence tax avoidance

Akbar, Kharabsheh, Poletti-Hughes, and Shah (2017) gave evidence that the presence of independent
directors moderates risk-taking behavior. While Richardson, Lanis, and Leung (2014) identified a negative
correlation between tax aggressiveness and proportion of outside directors. We predict that the existence of foreign
and independent directors would negatively affect tax-avoidance actions due to their non-affiliated positions, which
make them more likely to carry out business ethically:

H2: Independent directors negatively influence tax avoidance

Additionally, Choi, Sul, and Min (2012) found that foreign outside directors provide expertise and
independent monitoring over management. The presence of foreign directors can ensure the ethical actions from the
board:

H3: Foreign directors negatively influence tax avoidance

Capital Structure and Tax Avoidance

Capital structure is a combination of external financing that is obtained from debt and equity, and internal financing
in the form of retained earnings. The composition of capital structure is a crucial matter because it affects a firm’s
capability to maximize its value. The Pecking Order theory (Myers and Majluf, 1984) states that in financing
activities, companies would prefer internal to external financing. At such conditions where external financing is
required, then debt would be preferred to equity, due to the lower capital cost and the advantage of tax savings.

In China, Chen, Jiang, and Lin (2014) showed that larger firms would favor debt financing, thereby
supporting Myers and Majluf’s Pecking Order theory. While in South Africa, Ramjee&Gwatidzo (2012) proved that
tax was negatively related to leverage. Pecking Order model shows that tax benefits would arise from the
employment of debts. When firms rely more on debt securities, they would benefit from interest expense, which are
taxable deductions. This would decrease taxable income and consequently, the income tax a firm has to pay.

H4: Leverage positively influences tax avoidance

Moreover, we would also like to assess whether capital structure intervenes the relationship between BOD
and tax avoidance. This is tested to determine whether capital structure decisions are made by board of directors
with a consideration to avoid taxes.

H5: Board characteristics influence tax avoidance through capital structure

Tax Avoidance and Profitability

Previous researches on tax avoidance and firm performance have shown inconsistent results (Chen et al., 2014).
Desai and Dharmapala (2009) showed that in companies with good corporate governance, tax avoidance is found to

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 The Determinants And Economic Consequences Of Tax Avoidance In Indonesia: The
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increase firm value, while in firms with poor governance, avoiding taxes turn out to be damaging the firm value. A
number of studies also argued that tax-avoidance practices require high costs (Khan and Schmidt, 2013; Chen et al.,
2014). Costs that are actually paid (e.g. penalty for avoiding taxes) and could potentially occur (e.g. firm value
impairment and increase in agency cost). Meanwhile, Chen et al. (2014) found that tax avoidance would increase
agency cost and decrease firm value.

Furthermore, Desai and Dharmapala (2009) also argued that avoiding taxes is a form of agency problem,
i.e. managerial opportunism. Tax avoidance provides justifications for managers to lower income tax: prioritizing
the shareholders first.

Traditional view argues that tax avoidance would increase cash flow to the firm so that it could be used to
improve company performance. As firms avoid paying income tax expenses, they would be able to generate more
after-tax earnings. This enables firms to generate higher profitability:

H6: Tax avoidance positively influences current profitability

METHODOLOGY

Sample Selection
Our sample comprised all the public manufacturing corporations, whose stocks were listed in the Indonesian Stock
Exchange from 2010 through 2015. Companies without complete financial information were excluded, along with
companies suffering operating losses (Zimmerman, 1983), because it could tamper with income tax calculations.
After processes of filtering, the total number of observations was 452 firm-years. Outliers were eliminated for
observations that possessed variables whose values were ± three times the standard deviation.

Table 1. Description of Variables

Variable Description

ETRIT Measure of tax avoidance: Income tax expense divided by accounting income before tax for
company i in year t

LEVit Measure for capital structure using leverage: Asset-equity ratio for company i in year t

WOMENIT Proportion of BOD members who are female for company i in year t

INDIEIT Proportion of BOD members who are independent for company i in year t

EXPATIT Proportion of BOD members who are foreigners for company i in year t

ROEit Return on Equity for company i in year t

Control
Variables:
Number of years which company i has been publicly-traded, computed as observed year i
LNAGEI T deducted by year of (IPO) listing

LNSIZEIT Size of company i in year t, measured with natural logarithm of total assets

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Tax Avoidance Measure

We employ Effective Tax Rate (ETR) as measure of tax avoidance. It is computed as income tax expense divided by
earnings before taxes. The number presents the proportion of generated accounting income, payable as taxes. ETR
has been widely used in tax avoidance studies (Stickney and McGee, 1982; Desai and Dharmapala, 2009; Salihu,
Obid, and Annuar 2013; Taylor and Richardson, 2014)

Data Analysis

Our models were analyzed using panel data regression with random-effects on the EViews software:

I. The effects of capital structure and board characteristics on tax avoidance

ETRit=α0+α1LEVit+α2WOMENit+α3INDIEit+α4EXPATit+α5AGEit+ α6LnSIZEit+εit

II. The Indirect Effect of Capital Structure on the Relationship between Board Characteristics and Tax Avoidance

ETRit=α0+α1MODEL1it+ +εit; where

MODEL 1: LEVit=α0+α1WOMENit+α2INDIEit+α3EXPATit +εit

III. The effect of tax avoidance on profitability

ROEit = α0+α1ETRit+α2LnSIZEit+α3LnAGEit+εit

Control Variables
We include control variables that could affect debt usage and tax avoidance: (a) firm age (b) firm size (c) growth
opportunities. Firm age is the length of duration that the firm has been listed in the stock market. Beasley (1996)
found that the longer a company had been publicly traded, the more possible for them to make changes in order to
comply with public market regulations. Firms with more years of experience would have a better understanding of
the rules of the game and therefore more cautious when it comes to avoiding taxes.

We also control for firm size. Larger firms have more financing options compared to smaller ones. They
also tend to be diversified; acquiring subsidiaries from a range of different industries. Hence the inclusion of total
assets as a proxy for firm size.

FINDINGS & DISCUSSION

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Table 2. Descriptive Statistics

WOMEN INDIE EXPAT LEV ETR ROE

Mean 0.111964 0.084360 0.206291 2.005193 0.299018 0.155580

Median 0.000000 0.000000 0.000000 1.740329 0.256348 0.124509

Maximum 0.666667 0.666667 1.000000 5.308877 0.809589 0.594800

Minimum 0.000000 0.000000 0.000000 1.000000 0.001219 -0.126104

Std. Dev. 0.161067 0.136834 0.289699 0.912763 0.154866 0.143227

Skewness 1.298113 1.627160 1.156215 1.973597 1.857855 1.528129

Kurtosis 3.902548 5.012297 3.009445 7.315767 6.343135 5.325336

Jarque-Bera 142.2856 275.7188 100.7098 644.2166 470.5142 277.7521

Probability 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000

Sum 50.60763 38.13066 93.24337 906.3473 135.1563 70.32206

Sum Sq. Dev. 11.70014 8.444293 37.85039 375.7443 10.81656 9.251801

Observations 452 452 452 452 452 452

The corporations we observed were not highly diverse in terms of gender with an average of 11 per cent women on board
of directors. While independent directors averaged 8% (high variance) and foreign directors averaged 20% (low variance)
across the board. Based on the aforementioned description, it can be determined that women directors, independent
directors, and foreign directors are not large in numbers for Indonesian manufacturing corporations.

Furthermore, from LEV, we can conclude that the majority of the corporations finance their assets externally. ETR
averaged 29.9%, which is higher than Indonesia’s corporate income tax rate at 25%, reflects the low tax avoidance
executed by the corporations. Whereas the industry experienced an average ROE of 15.5%

1. The Effects of Board Characteristics and Capital Structure on Tax Avoidance - RANDOM
ETRit=α0+α1LEVit+α2WOMENit+α3INDIEit+α4EXPATit+α5AGEit+ α6LnSIZEit+εit

Table 3. Testing of Hypotheses 1, 2, 3, and 4

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Variable Expected sign Coefficient P-value

C +/- 0.359732 0.0002

LEV - 0.039972 0.0000***

WOMEN + 0.022931 0.6730

INDIE + 0.160749 0.0043***

EXPAT + -0.060140 0.0840**

LnAGE -0.013309 0.5233

LnSIZE -0.003785 0.1564

Adjusted R-Square 0.057397

Prob> F 0.000014

N 452 unbalanced observations, 110 cross-sections included

Dependent variable= Tax Avoidance (ETR)

Note: Observed variables are in bold letters

LnAGE and LnSIZE are control variables.

P-values are one-tailed

Statistical significance is denoted with asterisks:

***, **, and * correspond to 1%, 5%, and 10% levels of significance, respectively.

Based on regression analysis, INDIE and EXPAT are found to significantly influence ETR at 1% and 10%
significance levels, respectively. Our observed board characteristics affect tax avoidance, thereby supporting the
arguments of previous studies that executives possess significant effects on tax avoidance (Evertsson, 2016; Dyreng
et al, 2010).

Table 3 shows that a board consisting of more independent directors would veer away from tax avoidance;
accepting H2. This finding corresponds with Richardson, Lanis, and Leung (2014). The existence of independent

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directors on boardroom proves to be an effective management oversight mechanism, ensuring good corporate
governance and neutralizing risk-taking and opportunistic behaviors.

Furthermore, EXPAT is revealed to negatively affect ETR; prompting tax avoidance-- H3 is rejected. We
can determine that a firm would be more likely to avoid taxes when the board is composed with more foreigners. In
their organizational management, they tend to weaken control systems (Schwizer et al., 2013). Their low attendance
on board meetings may be due to the fact that foreign nationals are not always present in Indonesia. This condition
could explain weakened oversight process. Otusanya (2011) has also found that some multinational companies
engage in tax evasion and avoidance. Salihu, Annuar, and Obid (2015) also proved positive relationships between
foreign investors’ interests and measures of tax avoidance. It could be the case that foreign directors would take part
in tax avoidance because foreign presence in companies have their own interests. Expatriates may also not possess
the patriotism to contribute wealth to the nations that are not of their nationality.

Meanwhile, H1 is rejected because the presence of female directors neither causes nor hinders tax
avoidance. Siantar (2016) found that board gender diversity did not to affect firm financial performance. It may be
possible that the promotion of women on BOD is motivated by reasons for diversity, or the amount of female
directors on board is just low—the BOD of our observed corporations only averaged 11% women. As Harris (2014)
has shown that the effects of women on top management would be more significant when there are more women
directors.

Finally, LEV is found to positively affect ETR at 1 per cent significance level. Companies that employ more
debt in financing generate higher ETR or pay more taxes, i.e. not avoiding them. We therefore reject H4. Our result
contradicts the majority of past findings, from Stickney and McGee (1982) to Amidu, York, and Harvey (2016).
Moreover, Table 2 shows that the ETR variable averages 29.9%, which is higher than the 25% corporate tax rate.
This indicates that Indonesian manufacturing corporations declare their income taxes appropriately.

It may be in the best interests of all stakeholders not to avoid taxes. Leveraged-firms are responsible for
honoring their liabilities toward creditors. They already hold business risk, such as credit or default risk, without
adding in the risks of tax avoidance.

2. The Indirect Effect of Capital Structure on the Relationship between Board Characteristics and Tax Avoidance

ETRit=α0+α1MODEL1it+ +εit; where

MODEL 1: LEVit=α0+α1WOMENit+α2INDIEit+α3EXPATit +εit

Table 4. Testing of Hypothesis 5

Variable Expected sign Coefficient P-value

C +/- 0.222987 0.0000

MODEL 1 0.040246 0.0003***

Adjusted R-Square 0.025883

Prob> F 0.000349

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N 452 unbalanced observations, 110 cross-sections included

Dependent variable= Tax Avoidance (ETR)

Note: Observed variables are in bold letters

*** corresponds to 1% level of significance

The p-values are one-tailed.

We present that BOD characteristics affect tax avoidance through capital structure (significant at 1 per cent),
therefore accepting H8. We can conclude that board characteristics enhance the influence of capital structure on tax
avoidance. This finding indicates that one of the decision-making considerations for the board to determine capital
structure is the possibility of tax avoidance. Financing strategy is executed by firms attempting to manage their
taxes.

Capital structure decision is a crucial matter because it has long-term consequences, particularly regarding
a firm’s going-concern and sustainability. When a company aspires to finance itself by offering capital stock,
company control would be shared with the external shareholders. Whereas in the events of debt instrument
issuance, a firm is faced with default risk, while also experiencing tax shield.

In our investigation, we find that financing decisions are significantly influenced by board characteristics,
and one of the considerations in determining capital structure is the possibility of avoiding taxes. The corporations
we observed tend to utilize resources that enables tax avoidance.

3. The Effects of Tax Avoidance on Profitability - (Fixed effects model)

ROEit = α0+α1ETRit+α2LnSIZEit+α3LnAGEit +εit

Table 5. Testing of Hypothesis 6

Variable Expected sign Coefficient P-value

C +/-

ETR - -0.136798 0.0000

LnAGE -0.109167 0.0002

LnSIZE 0.002725 0.2172

Adjusted R-Square 0.760482

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Prob> F 0.0000

N 452 unbalanced observations, 110 cross-sections included

Dependent variable= Profitability, measured with ROE

Note: Observed variables are in bold letters

LnAGE and LnSIZE are control variables.

P-values are one-tailed

Statistical significance is denoted with asterisks:

***, **, and * correspond to 1%, 5%, and 10% levels of significance, respectively.

Table 4 shows that ETR negatively influences ROE at 1 per cent level, which means that lower ETR (higher tax
avoidance) increases firm profitability. As a result, hypothesis 8 is accepted. Our finding supports the traditional
view that tax avoidance provides additional resources for the firm to generate income. We can determine from our
analysis that top management prioritizes the interests of the firm, and not the country. Resources, which were
supposed to be contributed into the income of the state, have been diverted to the shareholders and the management
for their use. Additionally, our finding is line with Rego (2003), who found that in the USA, firms with lower taxes
have greater income.

CONCLUSION

1. Conclusion
Independent directors are found to negatively influence tax avoidance, whereas foreign directors affect tax
avoidance positively. Capital structure, measured with firm leverage, is revealed to negatively affect tax avoidance.
Tax avoidance is also found to positively affect profitability, measured with ROE.
In summary, our findings indicate that composition and characteristics of board of directors directly influence the
decision to avoid taxes. Independent directors mitigate tax avoidance, while foreign directors sustain them.
Moreover, highly-leveraged firms tend to not avoid taxes for the risks it carries, even though it may increase current
firm profitability.
Lastly, it is also suggested that tax avoidance is executed strategically by management through the determination of
firm financing activities, as proven by the enhancing effect capital structure has on the relationship between board
characteristics and tax avoidance.

2. Implication
We offer evidence that financing strategy determines tax avoidance. The implementation of Ministerial Decree of
Finance 169/PMK.010/2015 concerning the Determination of the Comparison between Liabilities and Capital of
Company for the Calculation of Income Tax can be relevant. The government, through the Directorate General of
Taxes (DGT) should socialize and enforce this law to mitigate tax avoidance, in order to increase state income for

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the country’s development. The DGT can also perform tax audit or monitoring by taking BOD characteristics into
consideration.

3. Limitation

We only observed publicly-traded manufacturing corporations. To obtain a more generalized results, future studies
should include more samples from different industries. Furthermore, our investigation did not analyze the possibility
of difference in employment of corporations’ liabilities prior and subsequent to the release of the Ministerial Decree
of Finance 169/PMK.010/2015 in 2015.

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