Tax impact on the financial performance of companies [605491]

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 Tax impact on the financial performance of companies

Author: Neghin ă (Lăcătuș) Andreea Laura
Coordinator: Prof.univ.dr. Vintil ă Georgeta

Abstract: National and international literature addressi ng various aspects of the impact problem
profits tax on corporations and the results of management deci sions, specifically targeting the
financing decision. Financial structure determines the effects on profitabi lity and the company's
profitability, influencing in this way, the valu e of the company. This paper uses data for 25
companies listed on the Bucharest Stock Exch ange between 2006-2011. This paper finds a
negative correlation between the effective tax rate , interest rate and performance, and a positive
correlation between leverage, firm size, rela tive growth of the company and financial
performances. This paper aims to validate some theories of increased leverage increases
company performance.
Keyword: Corporate taxation, tax profit, eff ective tax rates, performance, leverage

1. Introduction
Taxation of corporate profits, as an important component of fiscal policy, is a topical
issue of great interest impacting bo th macroeconomic and microeconomic.
By imposing taxes, the state seeks to colle ct financial resources to the budget. When
referring to the economic, tax, representing a sampli ng of financial resources at their disposal to
the state, have the effect of reducing economic and financial performance achieved.
At first glance, the action has the same tax on financial performan ce manifestation way,
regardless of the company to which it relates. But note that not all co mpanies understand the law
in the same manner and not all take advantag e of tax breaks that rule by law to offer.
The study of this paper aims to present and discover those indicators which influence the
performance of an enterprise taxation presence and offer solutions that businesses can use
taxation, and more specifically the ta xation of profits in their favor.
2. Literature review

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 National and international literature addressi ng various aspects of the impact problem
profits tax on corporations and the results of management deci sions, specifically targeting the
financing decision. Financial structure determines the effects on profitabi lity and the company's
profitability, influencing in this way, the value of the company.
Depending on the influence that each funding s ource part has on the fi nancial results and
financial performance, in terms of taxation, comp anies can choose to use either the predominant
own resources or borrowed resources.
Politics election financing struct ure involves balancing the degr ee of risk to the rate of
return. Increasing leverage increases risk leve l but may be accompanied by a higher expected
rate of return.
A company can use leverage as a way to incr ease its financial perf ormance by identifying
the optimal ratio of capital borrowed and equit y. Leveraged growth can lead to a financial
structure that generates tax savi ngs due to the deductibility of in terest expenses, bank fees and
even due to the fact that they are tax deductible in the calculation of depreciation expense for the
investment projects which probably Additional loans were contracted. In conclusion, in the
presence and under profits tax debt , the market value of equity in creases with the amount of tax
savings resulting from the deductibility of interest.
The literature study taxation of corporate profits begun decades ago and has grown
especially in recent years. Baseline is marked by Modigliani and Miller st udied the influence of
taxation on capital structure. Th e authors of the study concluded that the choice between debt
and equity financing has no impact on firm value in certain circumstances. They assumed that
there is no tax, no increase, depreciation is zero and the firm will last forever.
After studies of Modigliani and Miller , studies focused on relaxing the initial
assumptions of the model by intr oducing "his imperfections in order to adopt the relevant
financial decision. In the initial study of Miller and Modigliani, in a perfect market condition tax
rates on interest, dividends and capital gains were equal to zero and no matter if the company is
financed by debt or equity as the value of a levered firm wa s equal value of an unlevered
company, no matter the relationship between equity and debt value.
The model corrected in 1963, consider taxing pr ofits but the assumpti on that the tax rate
on interest and dividend is zero. However, two further considers that the tax savings generated
by interest deductibility and liabilities are risky as they have generated. Thus this model shows
that firms should finance 100% of the debt in orde r to increase firm value because the tax benefit
of using debt seems to depend only on the borrowe d sources, apart from the costs of using these
resources.

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 The following studies taking into account taxe s on interest and capital gains, it was
observed that borrowing can lead to an increase in the company but this is true only when the dividend tax rate is less than or e qual to the rate imposing interest.
In 1979, based on the model of Miller and Modigliani, economists Peles and Sarnat
conducted an empirical study on the example of the change in tax law in the UK, which
measured the impact of taxation on the financia l structure of the compa ny. The study noted that
these tax changes had a pronounced impact on the funding policies of companies. Prior to 1966,
British companies have been subjected to income tax and income tax. A differentiated tax was
introduced on dividend as profits distributed were subjected to both income taxes and the
income. This movement of tax legislation provid ed an incentive to rei nvest corporate profits
leading to deleveraging of the company.
DeAngelo and Masulis (1980) proposed a model th at provide an optimal level of debt and
found that the marginal benefit of debt is even worse, as the tax base is reduced by other non-
cash expenses deductible.
According to the Modigliani-Miller, the firm is inversely proportional to the weighted
average cost of capital. Therefore, changes in tax law that lowers tax rates should increase firm
value. Consequently, Downs and Hendershott (1987) showed that changes to the tax legislation
of 1986 tax reform would increase the value of companies from 10% to 13%.
In 1987, Mauer and Lewellen conducted a study that showed the debt problem by
increasing the long-term debt financing stru cture, a company becomes more valuable.
In 1990, Mackie-Mason found that there is a substantial eff ect of taxation on the choice
of financing structure. The orga nization is closer to the point where the source tax benefits are
exhausted, the effect of tax savings is becoming increasingly important. In conclusion, each
monetary unit must be assessed additional interest deducted using a marginal tax rate, which is a
decreasing function of th e interest charges.
In Romania, a recent study by Tatu Lucian (2006) tested the applicability of the
Modigliani-Miller model in Fica l conditions on Romania's case, ta king into account the specific
nature of the interest deductib ility. Study results showed that the surplus value of a company
indebted compared to unlevered one is influen ced by the tax rate and the share of deductible
interest expense Total interest. If all interest expenses would be tax de ductible when not affect
the company's financial structure.
Analyzing all correlation-tax profits fina ncing structure of the company, numerous
studies (Stickney and McGee (1982 ), Graham (1996), Gupta and Ne wberry (1997), Derashid and
Zhang (2003), Richardson and La nis (2007), Md Nor et al ( 2010)) found that there is an
interdependent relationship between effective tax rate and financial structure (measured by
leverage variable) in most of the studies em phasizing a negative correl ation between these two

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 variables. Other studies (Huizi nga and Nicodeme, 2006) have dete rmined a positive relationship
between the level of taxation in European and foreign capital.
Tax impact on the financial structure of the company is surprised and more recent studies
(Wu and Yue, 2009), which examined such as adjust their capital structure of listed companies in
China, in response to increasing th e rate of profit . The conclusi ons were: increasing the rate has
increased leverage which is correlated with the de gree of access to bank loans, so the availability
of funding sources may be an important determinant of capital structure.
In 2003, using information provided by the ma nagers of companies from 17 European
countries, Bancel and Mittoo followed the link be tween theory and practi ce. Some preliminary
conclusions were that the most important fact ors that influence debt policy are financial
flexibility, the rating company granted by credit institutions and tax benefits of debt and net
income per share is the decisive element on equity financing.
Although tax leads to lower cost of capital borrowed should be considered carefully
because an excessive increase of capital borrowed comes with increased risks of borrowing.
Interest rate changes constantly and usually upside as the levera ge is higher as additional costs
for the company. All this can result in reverse effects to the desire d ie to decrease firm value.
In Romania, for a company to fully benefit fr om interest deductibility must meet certain
criteria. First indebtedness must be less than 3 (i n which case interest is fully deductible expenses
in the year in which it accrues) and secondly EBIT is positive and sufficient to cover interest
charges and bank fees. Otherwise, the comp any may receive partial tax advantage.
In addition to the financial structure, taxa tion influences the performance of business
profits. Thus, with interest expense and deprecia tion expenses are deductible expenses that may
influence the amount of income and hence tax due, depending on the policies of depreciation
used. The analysis deductible expenses or tax incentives that can benefit companies are elements
that may impact the tax liability of the company. Lead to a fi nancial structure resulting tax
savings due to the deductibility of interest expenses, bank fees and ev en due to the fact that they
are tax deductible depreciati on expense of investment projects which have probably been
contracted loans more. Thus, in the presence of taxation of profits and debt conditions, the
market value of capital increases by the amount of tax savings resulting fr om the deductibility of
interest.
By identifying the optimal ratio between equi ty and borrowed capital used in financing
activity, the company can use le verage as a way to increase its financial performance.
From a political economy perspective, tax bur den could be linked to company size. In
some studies it was found that small businesses ma y suffer in terms of average cost of capital
because they can not benefit from economies of s cale. On the other hand, large firms may have
more political power to negotiate their tax burden, particularly through trade unions, because

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 they are more mobile and have a greater impact on employme nt when moving or leaving a
market. This theory of political power (Siegfri ed, 1972) predict that la rge companies face lower
effective tax rate. On the other hand, political cost theory (Watts and Zimmerman, 1978) argue
that because of the high visibili ty and control, large companies will end up paying a higher tax
burden.
Ambiguous results have led to a number of empirical studies. Se veral authors have
estimated directly the size of the Company's eff ective tax rate. Siegfried (1972) estimate such a
relationship the U.S. and although the results seem to be influenced by a large presence of large
companies in some sectors, finds a negative re lationship between size (measured by assets) and
effective taxation. His results are consistent w ith the theory of political power and a similar
relationship is also found by Pocarno (1986). Such a negative relationship is however in contrast
with the findings of Zimmerman (1983), using U.S. data for 1948-1981 and believes that in
1971, the largest fifty companies were faced with significantly higher rates of tax actual profit
which confirms rather political cost theory.
In other studies, Gupta and Newberry (1997) for the U.S. and Janseen and Buijink (2000)
for the Netherlands found no str ong evidence of a relati onship, both using total assets to measure
firm size.
Analyzing eleven Member States of th e EU, U.S. and Japan between 1980 and 1999,
Nicodeme (2002) confirms the importance of ba lance sheet structures and finds a negative
relationship between size, measured by turnover and effective tax rate s. His results show that, on
average, the turnover below the th reshold of 7 million going to th e effective tax rate 23% higher
than for companies with a turnover exceeding 40 m illion euros. A negative relationship is also
found and Nicodeme and Huizinga (2006), the size is measured as the logarithm of total assets.
3. The data
The database is composed of financial and accounting indicators calculated using
information available in reports of compan ies for the period 2006-2011. The main source of
information was the database consisting of ba lance sheets and profit and loss accounts reported
www.bvb.ro respective companies.
Parameters relevant to the economic and fi nancial strength of th e companies selected:
1. Return on equity (ROE)
2. Return on Assets (ROA)
3. Financial Leverage (LF)
4. Effective tax rate
5. Firm size
6. Relative increase in total assets
7. Effective interest rate

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 The aim of the research is to see to what extent the information contained by all the
financial indicators of profitabi lity select fails to explain the variability of the sample.
We used a sample of 31 companies traded on the Bucharest Stoc k Bura in 2006 – 2011.
Data was used for testing software Eviews 7, where we used panel data, with the dependent
variable in the first instance and later ROA a nd ROE as other independ ent variables selected
financial indicators. The aim was to eliminate extremes of minimum and maximum and finally,
applying the selection criteria, th e study remained 25 companies.
4. The empirical results
ROE ROA
Coefficient Prob. Coefficient Prob.
C 0.245078 0.4039 0.222995 0.4168
LF 0.152863 0.0171 0.102406 0.0454
Relative increase in total assets 0.637322 0.0188 0.610988 0.0162
ETR -2.223207 0.0000 -2.132229 0.0000
Firm size 0.092001 0.0124 0.093372 0.0069
EIR -0.310378 0.0043 -0.274303 0.0068

R-SQUARED 0.877173 0.884898
F-STATISTIC 22.90213 24.65437
PROB (F-STATISTIC) 0.0000 0.0000

The analysis outputs can be observed that th e R-squared is about 0.88 in both cases.
Determining the ratio R2 (R-squared) shows that th e variation of ROE, ROA is due to that of the
88% change indicators to be included in the mode l. Also of particular importance and Adjusted
R-squared shows that it takes in to account the number of indepe ndent variables included in the
regression analysis. If the difference between these indicators would be signi ficant, this would be
the consequence of explanatory variables that showed significance were not included in the
model. Of course, in this case the differences are not relevant.
Regarding the F-statistic observed in both cases that is around 23 with associated
probability 0 (<0.05) which allows us to say that the whole model is good.
After analyzing the values of p-value shows that the error of rejecting the null hypothesis
is less than 0.05 for all variab les for both ROE and ROA for.
If financial leverage influen ce on the profitability of both shareholders and the company's
profitability is positive. This is e xplained by the fact that in the presence of taxation of profits in
terms of debt, increase enterp rise profitability through tax savings resulting from the
deductibility of interest. According halp et al. (1998), a higher proportion of borrowed capital in
the equity of the company leads to increased risk but may be accompanied by a higher expected
rate of return. This is possible but up to a certain limit. Taxing profits decrease but increase the

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 cost of borrowed capital excessive leverage increases risk associated with borrowing that leads to
interest rate changes generally its upside, whic h would generate additional costs and would get
an effect the opposite of the desi red effect. Thus profitability w ould decrease as increased costs
associated with the bankruptcy ri sk is greater than tax savings.
According to the results, the influence of the effective tax rate is negative. The same was
obtained in their studies and Derauhid and Zhang (2003) and Md Noor et al. (2010). The
negative correlation for economic profitability can be explained by the fact that businesses more
efficient and profitable record effective tax rate s lower, a possible reason that these companies
profitable by management, as much advantage of existing tax incentives . Note that the greatest
influence of all variables has effective tax rate.
Although when we got leverage a positive relati onship, if the effective interest rate is a
negative relationship. This can be explained by the fact that, although an increase in total could
lead to a point to improve performance, it is ne cessary that the rate is not increased since an
increase thereof would reduce the profitability of the company.
Company size is also an importa nt factor for the profitabili ty. Rajan and Zingales (1995),
and Titman and Wessels (1988) st ated that the larger companie s tend to be more diverse and
therefore they have less chance of failure, and achieve greater profitability. Equilibrium theory
predicts an inverse relationship between size and the probability of bankruptcy, whic h is actually
a positive relationship between size and leverage, default between size and profitability.
According to hierarchy theory, firms with large in creases most in need of funds and therefore can
be expected to borrow more and obtaining tax savings from interest deductibility. Also
depending on the structure of assets, it is expe cted that companies with a high proportion of
tangible assets in total assets to obtain higher returns due to th e deductibility of depreciation.
This is proven by Stickney and McGee (1982).

5. Conclusion
Regarding the issue of the impact of taxation on the financial performance of the
company, in general, and financial structure, in particular, there ar e numerous studies in national
and international literature (M odigliani and Miller, 1963; Grah am, 2003; Stancu, 2007; tattoo L.,
2006 Vintil ă G., 2005, Wu and Yue, 2009). The results of these studies showed that a way to
increase the financial performance of the company is to identify the optimal ratio between equity
and borrowed capital used in financing activity. In creasing debt can lead to financial structure
resulting tax savings associated with considerable interest deductibility.
Under the objective of maximizing the profit tax is a tax variable significant impact on
the financial performance of the company. In this context, the analysis of the effective corporate
tax rate and its determinants should be considered in the substantiation of management decisions.
Based on the results of previous studies a nd given special treatment in terms of tax
deductibility for interest expens es in the case of Romania, we conducted a study to identify the
influence of taxation on the financial performan ce of the company's profits. On the 25 companies

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 analyzed we found that increased indebtedness could result in an incr ease or decrease in
profitability but by maintaining current interest rate s. An increase in interest rates could lead to
lower profitability. This is normal because, in ge neral, the level of indebtedness increases the
risk and thus increase the interest rate changes and, most often it s upside. This can reach a point
where the marginal tax savings are outweighed by the costs.
We also analyzed the influence of the effectiv e rate of tax on compa ny profitability. As in
other studies (Derashid and Zhang, 2003) found a negative relationship be tween the two
variables. Thus, the effective tax rate is higher, the profitability decreases. I think this can occur
when there is a high share of non-deductible expe nses or considering a la rger company achieved
a higher taxable income re sulting in a tax burden.
Regarding firm size were found between this a nd profitability is a positive relationship
because it believes that larger firms tend to be more diversified and therefore have lower
probability of bankruptcy and achieve greater profitability. Also, if you resort to loans, we can
assume that these loans are used for various in vestment projects which, in turn, generates tax
savings through the deductibility of depreciation. Thus we can say indeed that firm size
positively influences company performance. The theory of political power (Siegfried, 1972)
predicts that large firms would face lower effective tax rates because they have the power to
negotiate. Instead, political cost theory (Wa tts and Zimmerman, 19787) argues that because of
visibility and control of la rge, large companies end up paying a higher tax burden.
Like previous models made in the literature, and models made in this paper shows some
weaknesses both lack of data and because of the many changes made on the Romanian fiscal.
In conclusion, the survey results to identify the impact of income tax on company
performance are consistent with some results ob tained in studies of international literature.

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