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Advances in Taxation
Environmental Uncertainty and Tax Avoidance

Henry Huang, Li Sun, Joseph Zhang,
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ENVIRONMENTAL UNCERTAINTY
AND TAX AVOIDANCE
Henry Huang, Li Sun and Joseph Zhang

ABSTRACT
This paper examines the relationship between environmental uncertainty and

tax avoidance at the firm level. We posit that managers faced with more
uncertain environments are likely to engage in more tax avoidance activities.
We find a significant and negative relationship between environmental uncer-
tainty and effective tax rates, and our results persist through a battery of
robust checks. We further find that managerial ability mitigates the above
relationship. Moreover, we find that small, highly leveraged, and innovative
firms operating in uncertain environments engage in more tax avoidance.
Keywords: Environmental uncertainty; corporate tax avoidance;
managerial ability
JEL classifications: M41; M19
INTRODUCTION
Environmental uncertainty refers to the variability of change that characterizes
environmental activities relevant to a firm’s operations.1 Major economic
trends and globalization caused by advanced technology and increased
competition may induce greater environmental uncertainty. In response to
Advances in Taxation, Volume 24, 83124

Copyright r 2017 by Emerald Publishing Limited
All rights of reproduction in any form reserved
ISSN: 1058-7497/doi:10.1108/S1058-749720170000024002
83
84 HENRY HUANG ET AL.
environmental uncertainty, managers often use their flexibility and discretion to

better adapt to environmental changes. Prior studies examine flexibility and dis-
cretion by managers in uncertain environments. For instance, Dunk and
Nouri (1998) find that managers tend to increase budgetary slack in a volatile
environment. Davila and Wouters (2005) suggest that the operating environ-
ment plays an important role in a firm’s budgeting process, and find that
companies increase slack as the demand on business processes increases and
service quality becomes harder to achieve. Ghosh and Olsen (2009) argue
that a volatile environment causes managers to respond strategically and
proactively to offset any negative effects, and find that managers use more
discretionary accruals when faced with a more volatile environment. In sum-

mary, prior literature suggests that managers faced with high environmental
uncertainty need to make corresponding changes to their strategies to better
cope with uncertainty and portray a less risky image of the company to
outsiders.
However, there is little research on the relationship between environmental
uncertainty and corporate tax avoidance. McGuire, Omer, and Wilde (2014)
suggest that operating uncertainty leads to uncertainty in future tax saving ben-
efits, causing a lower likelihood of investing in a tax shelter. Gallemore and
Labro (2015) find that firms operating in a more uncertain environment benefit
more from the quality of their internal information in helping them avoid pay-
ing more taxes. In our study, we posit that managers faced with more uncertain
environments are likely to engage in more tax avoidance activities, which are
reflected in lower effective tax rates (or higher unrecognized tax benefits). Prior
research (e.g., Davila & Wouters, 2005) suggests that environmental uncer-
tainty results in increased planning or budgeting activities of a firm. Tax plan-
ning is a major planning component, because taxes represent a significant cost
to a firm and a reduction in shareholders’ wealth, in that companies pay over
one-third of their profits in tax (Chen, Chen, Cheng, & Shevlin, 2010). Hence,
in more volatile environments, managers have greater incentives to engage in
tax planning activities. Hanlon and Heitzman (2010) suggest that many of a
corporation’s tax-planning activities are related to corporate tax avoidance.
Increased tax planning leads to more tax avoidance activities (Rego, 2003). We
further posit that managers’ ability mitigates the relationship between environ-
mental uncertainty and tax avoidance because prior studies link managerial
attributes with tax avoidance. For example, Desai and Dharmapala (2006)
assume that managers can extract rents generated by tax avoidance because
operational complexity is a requisite condition for tax avoidance. Francis, Sun,
and Wu (2015) find that managers’ ability is strongly related to a reduction in
opportunistic behavior such as tax avoidance.
Following prior studies (e.g., Dyreng, Hanlon, & Maydew, 2010; Hanlon &
Heitzman, 2010; Mills, Erickson, & Maydew, 1998), we use three effective tax
rates to measure tax avoidance (namely, annual book effective tax rate, annual
cash effective tax rate, and the long-run cash effective tax rate). Lower effective
Environmental Uncertainty and Tax Avoidance 85
tax rates indicate more tax avoidance activities or tax aggressiveness. Using a
large panel of data from 1993 to 2013, we find a significant and negative rela-
tionship between environmental uncertainty and effective tax rates, suggesting
that managers faced with more volatile environments are likely to engage in
more tax avoidance activities.2 Additionally, following prior studies (e.g.,
Hutchens & Rego, 2013), we use unrecognized tax benefits3 (UTBs) in our anal-
ysis as an additional tax avoidance measure. We find a significant and positive
association between environmental uncertainty and UTBs, suggesting that firms
in a more volatile environment are more tax aggressive. Our further tests show
that more-able managers mitigate the above negative relationship. We show

this relationship by applying the double sorting approach and multivariate
regression.
We also employ several additional tests. These tests include an alternative
environmental uncertainty measure, which is technology volatility of R&D and
capital expenditures,4 and the two-stage least squares (2SLS) regression
analysis. These additional tests provide consistent results. In our further cross-
sectional tests, we find that the relationship between environmental uncertainty
and the level of tax avoidance becomes stronger for small, highly leveraged,
and (patent-based) innovation-efficient firms.
This study makes the following contributions. First, our study links and con-
tributes to two streams of literature: tax avoidance and planning in the
accounting literature and organizational theory in the management literature.
Our study is among the first studies that examine the relationship between envi-
ronmental uncertainty and tax avoidance activities at the firm level. Our study
provides insight into the motivation for and objectives of tax avoidance given
the firm-specific context of environmental uncertainty. In addition, our study
answers the call in Hanlon and Heitzman (2010) for more studies on the deter-
minants of tax avoidance. Second, McGuire et al. (2014) find that firms faced
with a volatile environment are less likely to invest in a tax shelter. Our study
complements and extends McGuire et al. (2014) by investigating the impact of
environmental uncertainty on legal tax strategies using a much larger sample
and a variety of uncertainty measures. Third, Maydew (2001) calls for more
studies on the relationship between uncertainty and tax avoidance. Hence, our
study answers his call. Fourth, we incorporate managerial ability into our anal-
ysis and find that managers with greater ability play an important role in the
relationship between environmental uncertainty and tax avoidance. Hence, our
study contributes to the managerial ability literature and is related to the results
of Dyreng et al. (2010), which suggests that managerial fixed effects are impor-
tant determinants of firms’ tax avoidance. Fifth, from a practical perspective,
our study provides evidence that yields a richer understanding of how manage-
rial ability and certain operating environments affect firms’ tax avoidance.
Perhaps more importantly, our study provides evidence that firm risk is an
important factor related to tax planning and payment.
The rest of this paper is organized as follows. Second section presents the
literature review and hypotheses development. Third section describes the
research design and Fourth section presents the main results. Fifth section
presents the results of additional analyses. Sixth section concludes this study.
LITERATURE REVIEW AND HYPOTHESIS

DEVELOPMENT
Environmental uncertainty is defined as the variability of change that charac-

terizes environmental activities relevant to a firm’s operations (e.g., Ghosh &
Olsen, 2009). Environmental uncertainty is stochastic and unpredictable in
nature. Milliken (1987) concludes that environmental uncertainty represents
(1) an inability to predict as to the likelihood of future events (Duncan, 1972;
Pennings, 1981; Pfeffer & Salancik, 1978); (2) a lack of information to predict
cause-effect relationships (Duncan, 1972; Lawrence & Lorsch, 1967); and (3) an
inability to predict the outcomes of a decision (Downey & Slocum, 1975;
Duncan, 1972; Hickson, Hinings, Lee, Schneck, & Pennings, 1971; Schmidt &
Cummings, 1976).
Environmental uncertainty is a core concept in management and organiza-
tional theory (Dill, 1958; Duncan, 1972; Ghosh & Olsen, 2009; Lawrence &
Lorsch, 1967; Thompson, 1967). Thompson (1967, p. 159) suggests that “envi-
ronmental uncertainty is a fundamental problem with which top-level organiza-
tional administrators must cope.” Because the external environment is always
changing, it is critical for managers to cope with changes in order to succeed.
Snyder and Glueck (1982) suggest that a firm’s response to environmental
uncertainty has a significant impact on its performance. Ghosh and Olsen
(2009) suggest that, although the external environment places considerable con-
straints on firms, managers still have opportunities to respond strategically to
cope with uncertainty. In other words, when facing environmental uncertainty,
managers have discretion and flexibility to develop different strategies to sur-
vive and then achieve maximum returns for their shareholders and themselves.
Prior studies examine how managers use discretion to cope with environ-
mental uncertainty. Alexander (1991) shows that managers respond to environ-
mental uncertainty by decentralization. That is, top-level managers delegate
more responsibilities to low-level managers when the external environment
becomes more volatile. Cheng and Kesner (1997) reveal that firms allocate
more resources toward activities enhancing external market effectiveness in a
volatile environment. Dunk and Nouri (1998) find that managers tend to
increase budgetary slack in a volatile environment. Davila and Wouters (2005)
suggest that the environment plays an important role in a firm’s budgeting pro-
cess and find that companies increase slack more as the demand on business
processes increases and service quality becomes harder to achieve. Ghosh and
Olsen (2009) explore the impact of environmental uncertainty from an

earnings-management perspective and find that managers use more discretion-
ary accruals to mitigate the variability in reported earnings when faced with a
more uncertain environment.
The above studies on environmental uncertainty also suggest that a volatile
environment results in significantly increased planning activities, which help
managers better cope with the volatile environment. Tax planning is a major
planning component because taxes represent a significant cost to a firm and a
reduction in shareholders’ wealth in that companies pay over one-third of their
profits in tax (Chen et al., 2010). Hence, we expect a corresponding increase in
tax planning in a volatile environment. Hanlon and Heitzman (2010) suggest

that much of a corporation’s tax planning activities are related to tax avoidance
because firms have incentives to reduce their taxes. Complimentary to this, a
more volatile environment causes managers to seek more cost-saving opportu-
nities to stabilize their cash flows and present a less-risky image to shareholders
(Ghosh & Olsen, 2009). Hence, we expect that managers have incentives to seek
out tax savings, a major cost-saving component, in a volatile environment.
Following Hanlon and Heitzman (2010), we define tax avoidance as any
“reduction of explicit taxes per dollar of pre-tax accounting earnings.” Under
this broad definition, tax avoidance represents a continuum of tax planning
strategies, encompassing activities that are perfectly legal (e.g., municipal bond
investments) and more aggressive transactions that fall into grey areas (e.g., tax
inversion). Many prior studies have examined the determinants of corporate
tax avoidance activities, with a focus on the relationship between firm-level
characteristics and tax avoidance (Hanlon & Heitzman, 2010). For example,
Gupta and Newberry (1997) examine a wide range of determinants of GAAP
effective tax rate and find that tax avoidance is associated with firm characteris-
tics including firm profitability, leverage, and capital intensity. Chen et al.
(2010) find that family firms are less likely to engage in tax avoidance activities.
Dhaliwal, Huang, Moser, and Pereira (2011) find that firms with lower cash
holdings are more likely to engage in tax avoidance. Cheng, Huang, Li, and
Stanfield (2012) show that firms with higher hedge fund ownership are more
tax aggressive. Mills, Nutter, and Schwab (2013) find that firms with higher
political costs are less likely to engage in tax avoidance. Higgins, Omer, and
Phillips (2015) examine the impact of business strategies on a firm’s tax avoid-
ance and find “prospector” firms are more tax aggressive, relative to “defender”
firms.
Other studies (e.g., Desai & Dharmapala, 2006; Phillips, 2003) show that
managers’ compensation is related to tax avoidance, suggesting that managers
have greater incentives to engage in tax avoidance when their compensation is
based on firms’ after-tax earnings. Desai and Dharmapala (2006) also find that
the relationship between compensation and tax avoidance is stronger in firms
with weaker corporate governance. Similarly, Rego and Wilson (2012) examine
the impact of aggressiveness on executive compensation and find that executives
are rewarded for being tax aggressive. Some studies examine the relationship
between managers’ attributes and tax avoidance. For example, Dyreng et al.
(2010) find that top executives play an import role in their firms’ tax avoidance
activities, and the level of tax avoidance varies significantly among individual
CEOs. Brown (2011) finds that firms that share (at least) one common board
member are more likely to demonstrate similar tax avoidance activities. Chyz
(2013) shows that executives who engage in stock option backdating are more
tax aggressive. Francis et al. (2015) find that managers with greater ability are
less likely to engage in tax avoidance, suggesting that more-able managers can
better identify other investment opportunities with higher returns than engag-
ing tax avoidance activities.

The above studies examine the determinants of tax avoidance. However, lit-
tle research has investigated environmental uncertainty as another determinant
of tax avoidance. McGuire et al. (2014) examine whether three investment fac-
tors (investment opportunity set, operating uncertainty, and capital market
pressure) influence the decision to invest in a tax shelter. Using 45 firms identi-
fied as participating in tax sheltering activities from 1985 to 2000, they find that
firms with greater operating uncertainty are less likely to make the decision to
invest in a tax shelter. Our study is related to McGuire et al. (2014),5 as both
studies investigate the impact of environmental uncertainty on a tax strategy.
Yet our study is different from McGuire et al. (2014) in the following perspec-
tives. First, their study focuses on the decision-making perspective of a tax
strategy, while our study focuses on the execution perspective of a tax strategy.
Specifically, they examine the likelihood of making an investment decision, and
we investigate the extent of a firm’s broad tax avoidance activities. Second, in
their study, the decision to invest in a tax shelter is merely a typical investment
decision, which is based on the net present value of future benefits and costs of
the investment. They argue that a volatile environment creates more uncertain-
ties (risks), making it difficult for a firm to make an investment decision. In our
study, we argue and find that the uncertainties or risks from a volatile environ-
ment cause managers to use more accounting discretions (i.e., tax avoidance
activities) to better cope with a volatile environment, consistent with Ghosh
and Olsen (2009). Both arguments are valid, and our results do not contradict
to those in McGuire et al. (2014). Indeed, our study complements and extends
McGuire et al. (2014) by investigating the impact of environmental uncertainty
on tax strategy from a different perspective. Moreover, we use a much larger
sample and a variety of uncertainty measures to yield a more generalizable
conclusion. Another related study is Gallemore and Labro (2015),6 who use a
dummy variable (High Volatility), which equals one when the factor of three
variables indicating contemporaneous uncertainty (absolute change in sales,
equity volatility over the current year, and change in equity volatility over the
prior year) and zero otherwise. However, they do not find evidence to indicate
a significant relationship between volatility (uncertainty) and cash effective
tax rate.7
If a more volatile environment causes more organizational planning activi-

ties, we expect that firms consequently increase their tax planning activities.8
Many of the tax planning activities attempt to lower effective tax rates. Tax
savings becomes more critical when the external environment becomes more
uncertain. Tax savings help firms stabilize cash flows, benefit shareholders, and
portray a less-risky image to shareholders. Thus, managers have greater incen-
tives to engage in tax avoidance activities in a more uncertain environment.
We, therefore, expect that environmental uncertainty and tax avoidance are
positively associated. We state our first hypothesis as follows:
H1: Environmental uncertainty is positively related to tax avoidance.

Managers play an important role in a volatile environment because they
need to know how to use discretion and flexibility to cope with an uncertain
environment (Ghosh & Olsen, 2009). Demerjian, Lev, and McVay (2012)
argue that more-able managers “better understand technology and industry
trends, reliably predict product demand, invest in higher value projects, and
manage their employees more efficiently than less able managers” (p. 1229).
Prior studies examine the importance of managerial ability from various
perspectives. For example, Demerjian, Lewis, Lev, and McVay (2013) exam-
ine the relationship between managerial ability and earnings quality. They
find that managerial ability is negatively associated with subsequent restate-
ments and errors in bad debt provision, and is positively associated with
earnings and accruals persistence, and with accrual estimation accuracy.
Baik, Farber, and Lee (2011) find a positive relationship between CEO abil-
ity and management earnings forecast issuance. Wang (2013) examines the
informativeness of insider trades conditional on managerial ability and finds
that more-able managers have greater net insider sales before the earnings
break than do less-able managers. Demerjian, Lewis-Western, and McVay
(2015) find that more-able managers better smooth earnings to benefit share-
holders than do less-able managers. Francis et al. (2015) find a strong rela-
tionship between managerial ability and effective tax rates, suggesting that
more-able managers engage in less tax avoidance activities, relative to less-
able managers. Krishnan and Wang (2015) find negative relationships
between managerial ability and both audit fees and going-concerns audit
options, suggesting that managerial ability plays an important role in audi-
tors’ judgement and efficiency. Overall, prior studies on managerial ability
suggest that more-able managers engage in fewer opportunistic behaviors
such as tax avoidance.9
Motivated by Francis et al. (2015), we incorporate managerial ability in
our first hypothesis (H1). We argue that more-able managers engage in less
tax avoidance activity and are more capable of adapting to a volatile envi-
ronment, relative to less-able managers.10 That is, when facing the same vol-
atile environment, more-able managers make better long-term decisions and
implement better strategies to adapt to the environment, instead of engaging

in more tax avoidance activities. Therefore, we expect that managers with
greater ability better mitigate the negative relationship between environmen-
tal uncertainty and effective tax rates, if observed. We state our second
hypothesis as follows:
H2: The relationship between environmental uncertainty and tax
avoidance becomes weaker if a firm’s managerial ability is stronger.
RESEARCH DESIGN
Proxies of Environmental Uncertainty
Tosi, Aldag, and Storey (1973) examine three environmental uncertainty mea-
sures: sales volatility, earnings volatility, and technological volatility. They find
that these measures are industry-specific, i.e., the correlations among the three
measures vary significantly by industry types. For example, the environmental
uncertainty measures are positively (negatively) correlated in manufacturing
firms (marketing firms). Snyder and Glueck (1982) examine two environmental
uncertainty measures in Tosi et al. (1973), namely, sales volatility and techno-
logical volatility, and find that both measures are objective. However, Ghosh
and Olsen (2009) suggest that sales volatility may be a better proxy, relative to
technological volatility. They argue that technological components (such as
R&D expenditures and capital expenditures) are often subject to management
discretion. For instance, managers often cut back R&D expenditures when the
external environment becomes more uncertain. Hence, Ghosh and Olsen (2009)
suggest that, unlike sales volatility, technological volatility is “more of a
response by management to the external environment as opposed to a direct
measure of environmental uncertainty” (p. 193). Prior management and
accounting literature (e.g., Kren, 1992; Milliken, 1987) also suggest that sales
volatility is an appropriate proxy for firm’s environment.
Following prior studies said above, we use the coefficient of variation (CV)
of sales, scaled by total assets, to capture sales volatility as our primary
environmental uncertainty measure. The formula to calculate the raw sales
volatility is expressed as below:
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
P5
ðSi Smean Þ2
5
i¼1
CVðSi Þ ¼
Smean
where Si is a firm’s sales (scaled by total assets) in year i and Smean is the
mean of sales (scaled by total assets) over a rolling five-year period. We
calculate CV of sales by year and industry (using two-digit SIC code).

Following Ghosh and Olsen (2009), we normalize the raw firm-specific envi-
ronmental uncertainty by dividing it by the average environmental uncer-
tainty for that firm’s industry for the same fiscal year to mitigate time and
industry effects. A higher value of CV of sales indicates a higher level of
environmental uncertainty.
Measures of Tax Avoidance

Following prior literature, we use three measures of tax avoidance. The first
measure is the (annual) book effective tax rate (GAAPETR), a commonly used
measure of tax burden (e.g., Dyreng et al., 2010; Higgins et al., 2015; Phillips,
2003; Rego, 2003). We define the book effective tax rate (GAAPETR) as total
tax expense divided by pre-tax book income less special items. The calculation
of GAAPETR is expressed as below:
Total income tax expense ðTXT; 16Þ

GAPPETR ¼
Pretax book income ðPI; 170Þ Special items ðSPI; 17Þ
The above book effective tax rate to proxy for tax avoidance has some lim-
itations. First, this measure is accrual-based. Thus, it may exclude potential tax
savings from tax avoidance activities, such as accelerating expense deduction or
delaying revenue recognition, that create temporary book-tax differences.
Second, the book effective tax rate may include tax contingencies or cushions
associated with uncertain tax position taken on tax returns. Thus, it may under-
state a firm’s tax aggressiveness.
To overcome the two limitations with the book tax rate, we use the (annual)
cash effective tax rate as our second measure of tax avoidance. Following
Dyreng et al. (2010), we define the (annual) cash effective tax rate (CASHETR)
as total cash tax divided by pre-tax book income less special items. The calcula-
tion of CASHETR is expressed as below:
Cash tax paidðTXPD;317Þ

CASHETR ¼
Pretax book income ðPI; 170Þ Special items ðSPI; 17Þ
However, the cash effective tax rate is also subject to some measurement
errors.11
To mitigate the above measurement errors with CASHETR, we also use long-
run cash effective tax rate. Following Dyreng, Hanlon, and Maydew (2008), we
define the long-run cash effective tax rate (CASHETR5) as total cash tax over a
five-year period divided by pre-tax book income less special items over the same
five-year period. The main benefit of long-run cash rate is that this measure
avoids year-to-year volatility in annual tax rates. CASHETR5 takes into account
the tax benefits of employee stock options, whereas GAAPETR5 does not
(Dyreng et al., 2008). In addition, this measure avoids much of the mismatch of
cash taxes and earnings (Hanlon & Heitzman, 2010). The calculation of
CASHETR5 is expressed as below:
Σ Cash tax paid ðTXPD;317Þ

CASHETR5 ¼
Σ [Pretax book income ðPI; 170Þ Special items ðSPI; 17Þ]
Measure of Managerial Ability
Demerjian et al. (2012) develop a summary measure of managerial ability, a

performance-based measure of managers’ efficiency in using their firms’
resources to generate revenue. They use a two-step approach to develop the
measure. In the first step, they use Data Envelopment Analysis (DEA) to esti-
mate total firm efficiency by industry and year. Given a collection of points
in a multidimensional space, DEA fits a piecewise linear envelope or frontier
to the given data. The envelope indicates a normative ideal given the existing
data. Hence, points located on the envelope are optimally efficient, while
points below the envelope are inefficient. DEA evaluates all points with
respect to their deviation from the frontier. The value of the points on the
frontier equals 1, and the values of other points which operate beneath the
frontier are between 0 and 1. Using DEA requires identifying input and output
variables. Demerjian et al. (2012) use seven input variables: cost of goods sold;
selling, general and administrative expenses; property, plant and equipment;
operating lease; research and development cost; goodwill; and other intangibles.
The output variable in Demerjian et al. (2012) is net sales. Demerjian et al.
(2012) acknowledge that total firm efficiency can be attributed to both
manager-specific characteristics and firm-specific characteristics. Therefore, their
second step is to attempt to identify the manager-specific characteristics of the
total firm efficiency from DEA results. Thus, Demerjian et al. (2012) regress
the total firm efficiency on six firm-specific variables that could aid or hinder
managers’ ability. These six variables include firm size, firm market share, cash
available, firm age, operational complexity, and foreign operations. This regres-
sion is run by industry and with year-fixed effects to purge industry and year
effects. Demerjian et al. (2012) use the residuals from the regression as proxy
for managerial ability (MASCORE). We further transform the raw residual
scores in Demerjian et al. (2012) into an industry-based quintile ranking
(MARANK) for a given year.
Model Specification
We use the following regression model to test the association between firms’
environmental uncertainty and corporate tax avoidance:
TAXAVOIDi;t ¼ β0 þ β1 EUi;t þ β2 SIZEi;t þ β3 LEVi;t þ β4 MTBi;t þ β5 NOLi;t

þ β6 CHGNOLi;t þ β7 ROAi;t þ β8 FIi;t þ β9 PPEi;t þ β10 RDi;t
ð1Þ
þ β11 EQINCi;t þ β12 INTANi;t þ β13 CASHVOLi;t
þ Industry & Year Indicators þ εi;t
In Eq. (1), the dependent variable (TAXAVOID) represents each of the

three tax avoidance measures, namely GAAPETR, CASHETR, and CASH-
ETR5. In testing the first hypothesis (H1), we expect a negative relationship
(i.e., β1 < 0) between environmental uncertainty (EU) and tax payment. We
also include control variables that are possibly associated with tax avoidance.
Following prior literature (e.g., Dyreng et al., 2008; Frank, Lynch, & Rego,
2009; Hope, Ma, & Thomas, 2013; Manzon & Plesko, 2002; Mills et al., 1998;
Rego, 2003), we control for market value (SIZE), leverage (LEV), market-
to-book ratio (MTB), loss carry forward (NOL), directional change in loss
carry forward (CHGNOL), return on assets (ROA), foreign income (FI), prop-
erty, plant and equipment (PPE), research and development (RD), equity
income (EQINC), intangible assets (INTAN), and volatility of operating cash
flows (CASHVOL). For example, large firms are less likely to engage in tax
avoidance activities because of potential political costs (Zimmerman, 1983).
Hence, we control for firm size (SIZE). MTB is included as high-growth firms
are less likely to engage in tax planning activities. We also control for NOL and
CHGNOL to observe whether firms have used the tax benefits from loss carry
forward. Chen et al. (2010) suggest that profitable firms are more likely to
engage in tax planning activities, and Hope et al. (2013) suggest that firms with
more foreign operations are more likely to engage in opportunistic tax behav-
ior. Hence, we control for return on asset (ROA) and foreign income (FI). We
control for PPE as the different treatment of depreciation expenses for tax and
book may affect firms with more capital equipment. We also control for RD,
EQINC, and INTAN to capture the different treatment of intangibles between
tax and book, and consolidated net income accounted for using the equity
method. McGuire et al. (2014) use volatility of operating cash flows to capture
operating uncertainty. It is likely that environmental uncertainty in our study is
related to volatility of operating cash flows. Hence, we include the volatility of
cash flows (CASHVOL) in our regression model. In the regression model, we
include the year and industry indicators to control for macroeconomic condi-
tions. To minimize the effect of outliers, we winsorize continuous variables
(except for the logged value of firm size) by year at the top and bottom one per-
centile level. Variable definitions are detailed in Appendix A.
To test our H2, we use the following model to examine the impact of mana-
gerial ability on the relationship between EU and tax rates:
TAXAVOIDi;t ¼ β0 þ β1 EUi;t þ β2 MARANKi;t þ β3 EUi;t × MARANKi;t

þ β4 SIZEi;t þ β5 LEVi;t þ β6 MTBi;t þ β7 NOLi;t
þ β8 CHGNOLi;t þ β9 ROAi;t þ β10 FIi;t þ β11 PPEi;t ð2Þ
þ β12 RDi;t þ β13 EQINCi;t þ β14 INTANi;t
þ β15 CASHVOLi;t þ Industry & Year Indicators þ εi;t
Francis et al. (2015) argue that capable managers are less likely to engage in
tax avoidance. We use the reverse quintile ranks of managerial ability
(MARANK) in Eq. (2). If H2 is valid, we expect a negative and significant
coefficient (i.e., β3 < 0) on the interaction between environmental uncertainty
and reverse ranks of managerial ability. The controls are the same as in Eq. (1).
Sample Selection and Descriptive Statistics
From Compustat we obtain financial statement data, which includes total

assets (AT, #6), book value of equity (CEQ, #60), common stock shares
(CSHO, #25), equity income (ESUB, #55), intangible assets (INTAN, #33),
total liabilities (LT, #181), net income (NI, #172), pre-tax income (PI, #122),
foreign income (PIFO, # 273), net property, plant and equity (PPENT, #8),
research and development expenditures (XRD, #46), stock price at fiscal-year
end (PRCC_F, #24), sales (SALE, #12), special items (SPI, #17), loss carry for-
ward (TLCF, #52), cash tax paid (TXPD, #317), tax expenses (TXT, #16), and
cash flows from operating activities (OANCF, #308). The initial sample from
Compustat including the above variables consists of 253,743 observations from
1988 to 2013. Next, we use non-zero sales to calculate EU. The sample consists
of 116,503 observations with EU data from 1993 to 2013 as the calculation of
EU relies on prior five years’ sales.
Following Dyreng et al. (2008), we delete observations with negative effec-
tive tax rates and winsorize effective tax rates greater than one to equal one.
We further delete sample firms in the financial industry (SIC code: 6000-6999).
Our tests require firms to have positive pretax income when summed over the
five-year period. This requirement removes many firm-year observations
(Dyreng et al., 2008). Our final sample with complete data to test Eq. (1) con-
sists of 27,594 observations from 1993 to 2013. We keep the same number of
27,594 observations to improve comparability across the three effective tax
measures (GAAPETR, CASHETR, and CASHETR5) to avoid changing both
the measures and the sample size in our analysis. To test H2, we use the mana-
gerial ability data (scores and ranks) by Demerjian et al. (2012). The final
sample to test Eq. (2) consists of 24,087 firm-year observations after we merge
the managerial ability data with our sample for testing H1.
Panel A of Table 1 presents sample descriptive statistics. The mean (median)
values of GAAPETR, CASHETR, and CASHETR5 are 0.324 (0.340), 0.276
(0.262), and 0.283 (0.280), respectively. These numbers are consistent with
Dyreng et al. (2008) who report that the mean (median) values of cash effective
rate and long-run cash effective rate over a five-year period are 0.270 (0.256)
Table 1. Simple Statistics and Sample Distribution.

Panel A: Descriptive Statistics
Variables Obs. Mean Std. Dev. 25th Pctl Median 75th Pctl
GAAPETR 27,594 0.324 0.151 0.261 0.340 0.382

CASHETR 27,594 0.276 0.197 0.143 0.262 0.364
CASHETR5 27,594 0.283 0.170 0.183 0.280 0.357
EU 27,594 0.203 0.185 0.152 0.220 0.392
EUTECH 27,594 0.756 0.539 0.396 0.622 0.963
UTBs 5,770 0.012 0.021 0.003 0.007 0.015
MASCORE 24,087 0.019 0.129 0.061 0.009 0.090
INNOVATION 27,594 0.130 0.219 0.000 0.051 0.168
ASSETS 27,594 3,872 11,235 146 634 2,593
SIZE 27,594 6.319 2.193 4.798 6.453 7.886
LEV 27,594 0.535 0.252 0.354 0.529 0.688
MTB 27,594 2.456 2.064 1.284 1.923 2.979
NOL 27,594 0.332 0.471 0.000 0.000 1.000
CHGNOL 27,594 0.002 0.010 0.000 0.002 0.007
ROA 27,594 0.051 0.087 0.024 0.048 0.086
FI 27,594 0.015 0.030 0.000 0.000 0.018
PPE 27,594 0.338 0.259 0.134 0.264 0.492
RD 27,594 0.023 0.044 0.000 0.000 0.027
EQINC 27,594 0.009 0.005 0.000 0.000 0.009
INTAN 27,594 0.144 0.186 0.000 0.064 0.226
CASHVOL 27,594 0.083 0.152 0.019 0.040 0.087
Notes: This panel reports the descriptive statistics of the variables. Specifically, this table reports
pooled means, standard deviations, 25th percentile, median, and 75th percentile of the dependent
variable, independent variables of interest, and control variables. This table presents the descriptive
statistics of the sample of 27,594 firm-year observations from 1993 to 2013 inclusive, with the
exceptions of the managerial ability measure which has 24,087 observations during the same sample
period, and the unrecognized tax benefits (UTBs) measure which has 5,770 observations as it
becomes available in 2006 and beyond. All continuous variables are winsorized at 1% and 99%
percentiles. See Appendix 1 for variable definition.
Table 1. (Continued )
Panel B: Sample Distribution by Fiscal Year
Year # of Percent of Cumulative Year # of Percent of Cumulative

Obs. Sample (%) Percent Obs. Sample (%) Percent (%)
1993 946 3.43 3.43 2004 1,402 5.08 52.83

1994 1,091 3.95 7.38 2005 1,569 5.69 58.51
1995 1,219 4.42 11.80 2006 1,599 5.79 64.31
1996 1,346 4.88 16.68 2007 1,498 5.43 69.74
1997 1,356 4.91 21.59 2008 1,397 5.06 74.80

1998 1,313 4.76 26.35 2009 1,348 4.89 79.68
1999 1,249 4.53 30.88 2010 1,466 5.31 85.00
2000 1,192 4.32 35.20 2011 1,393 5.05 90.04
2001 1,093 3.96 39.16 2012 1,384 5.02 95.06
2002 1,162 4.21 43.37 2013 1,363 4.94 100.00
2003 1,208 4.38 47.75 27,594 100.00
Notes: This panel presents the firm-year observations by fiscal year. The sample consists of 27,594
firm-year observations from 1993 to 2013.
Panel C: Sample Distribution by Industry
SIC-2 Description Obs. % SIC-2 Description Obs. %
01 Agricultural Crops 61 0.22 40 Railroad 119 0.43

02 Agricultural Livestock 7 0.03 41 Local/Suburban Transit 9 0.03
07 Agricultural Services 20 0.07 42 Motor Freight 261 0.95
08 Forestry 11 0.04 44 Water Transportation 159 0.58
09 Fishing & Hunting 2 0.01 45 Air Transportation 205 0.74
10 Metal Mining 165 0.60 46 Pipelines 8 0.03
12 Coal Mining 24 0.09 47 Transportation Services 98 0.36
13 Oil & Gas Extraction 892 3.23 48 Communications 703 2.55
14 Mining 62 0.22 49 Utilities Services 2,084 7.55
15 Building Construction 189 0.68 50 Wholesale Durable 970 3.52
16 Heavy Construction 150 0.54 51 Wholesale Nondurable 443 1.61
17 Special Construction 49 0.18 52 Building Materials 83 0.30
20 Food 1,014 3.67 53 General Stores 310 1.12
21 Tobacco 25 0.09 54 Food Stores 312 1.13
22 Textile 165 0.60 55 Automotive Service 161 0.58
23 Apparel 381 1.38 56 Apparel Stores 481 1.74
24 Lumber 221 0.80 57 Furniture Stores 191 0.69
25 Furniture 318 1.15 58 Eating & Drinking 536 1.94
26 Paper 391 1.42 59 Miscellaneous Retail 495 1.79
27 Printing 455 1.65 70 Hotels 83 0.30
Panel C: Sample Distribution by Industry
SIC-2 Description Obs. % SIC-2 Description Obs. %
28 Chemicals 1,742 6.31 72 Personal Services 135 0.49

29 Petroleum 231 0.84 73 Business Services 2,266 8.21
30 Rubber 399 1.45 75 Auto Repair 77 0.28
31 Leather 164 0.59 76 Other Repair 2 0.01
32 Stone Clay Glass 221 0.80 78 Motion Pictures 83 0.30
33 Primary Metal 474 1.72 79 Amusement 231 0.84

34 Fabricated Metal 636 2.30 80 Health Services 463 1.68
35 Industrial Machinery 1,882 6.82 81 Legal Services 6 0.02
36 Electronic Equipment 2,381 8.63 82 Educational Services 107 0.39
37 Transportation Equipment 898 3.25 83 Social Services 20 0.07
38 Measuring Instruments 1,954 7.08 87 Engineering & Accounting 511 1.85
39 Other Manufacturing 305 1.11 99 Nonclassified 93 0.34
Notes: This panel presents the firm-year observations by industry (based on the first two digits of
SIC code). The sample consists of 27,594 firm-year observations from 1993 to 2013.
and 0.291 (0.277), respectively. The mean and median values of EU are 0.203
and 0.220, respectively. The mean (median) value of MASCORE is 0.019
(0.009). Francis et al. (2015) report the mean (median) value of managerial abil-
ity score is 0.017 (0.007). Overall, the descriptive statistics are in line with prior
studies.
Panel B of Table 1 reports the sample distribution of firm-year observations
by fiscal year from 1993 to 2013. The sample observations show an upward
trend from 1993 to 1997 and a declining trend in the years of 1998 to 2001.
After the nadir in 2001, the sample size starts to increase until 2006 and reaches
a plateau during 2007 to 2013. Panel C of Table 1 reports the distribution of
firm-year observations by industry, based on the 2-digit SIC classification.
The most heavily represented industry is electronic equipment (8.63%, 2-digit
SIC: 36), followed by business services (8.21%, 2-digit SIC: 73), utilities services
(7.55%, 2-digit SIC: 49), measuring instruments (7.08%, 2-digit SIC: 38),
industrial machinery (6.82%, 2-digit SIC: 35), and chemicals (6.31%, 2-digit
SIC: 28).
Table 2 presents the correlation matrices for selected variables of sample
observations. For each pair of variables, the Pearson correlation coefficients
and related p-values are provided. We use Pearson correlation because of the
continuous nature of the primary variables such as EU and GAAPETR. We
observe significant and negative relationships between EU and the three tax
Table 2. Correlation Analysis.
98
GAAPETR CASHETR CASHETR5 EU MASCORE SIZE LEV MTB NOL CHGNOL ROA FI PPE RD EQINC
CASHETR 0.390
p-value <.0001
CASHETR5 0.275 0.480
p-value <.0001 <.0001
EU 0.038 0.062 0.105
p-value <.0001 <.0001 <.0001
MASCORE 0.065 0.080 0.059 0.092
p-value <.0001 <.0001 <.0001 <.0001
SIZE 0.027 0.027 0.083 0.021 0.220
p-value <.0001 <.0001 <.0001 0.056 <.0001
LEV 0.043 0.060 0.042 0.045 0.152 0.165
p-value <.0001 <.0001 <.0001 <.0001 <.0001 <.0001
MTB 0.053 0.068 0.077 0.034 0.132 0.364 0.071
p-value <.0001 <.0001 <.0001 0.000 <.0001 <.0001 <.0001
NOL 0.025 0.052 0.059 0.050 0.064 0.043 0.101 0.039
p-value <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001
CHGNOL 0.054 0.101 0.092 0.015 0.008 0.024 0.003 0.012 0.343
p-value <.0001 <.0001 <.0001 0.016 0.219 <.0001 0.610 0.040 <.0001
ROA 0.058 0.043 0.021 0.030 0.241 0.216 0.158 0.304 0.101 0.026
p-value <.0001 <.0001 0.000 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001
FI 0.125 0.058 0.057 0.068 0.115 0.293 0.017 0.194 0.001 0.097 0.184
p-value <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 0.005 <.0001 0.836 <.0001 <.0001
HENRY HUANG ET AL.

PPE 0.024 0.073 0.099 0.044 0.077 0.110 0.237 0.062 0.116 0.142 0.017 0.160
p-value <.0001 <.0001 <.0001 0.000 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 0.004 <.0001
RD 0.130 0.089 0.091 0.057 0.191 0.014 0.206 0.185 0.002 0.079 0.050 0.241 0.288
p-value <.0001 <.0001 <.0001 <.0001 <.0001 0.020 <.0001 <.0001 0.689 <.0001 <.0001 <.0001 <.0001
EQINC 0.011 0.016 0.010 0.029 0.066 0.115 0.072 0.033 0.017 0.009 0.027 0.041 0.045 0.054
p-value 0.059 0.008 0.098 0.010 <.0001 <.0001 <.0001 <.0001 0.004 0.204 <.0001 <.0001 <.0001 <.0001
INTAN 0.041 0.045 0.069 0.054 0.125 0.234 0.140 0.073 0.029 0.093 0.003 0.123 0.339 0.011 0.009
p-value <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 0.594 <.0001 <.0001 0.081 0.143
Note: This table presents the Pearson correlation analysis based on 27,594 observations during the sample period 19932013 inclusive, except for managerial ability (MASCORE) that has 24,087 observations dur-
ing the same period. For each pair of variables, the Pearson correlation coefficients and related (two-tailed) p-values are provided. All continuous variables are winsorized at the first and 99th percentiles before the
correlation analysis. Refer to Appendix 1 for variable definitions.
avoidance measures (namely, GAAPETR, CASHETR, and CASHETR5) with

correlation coefficients: 0.038, 0.062, and 0.105, respectively. The negative
correlations suggest that firms are more likely to engage in tax avoidance activi-
ties when faced with more volatile environments. We also observe that manage-
rial ability (MASCORE) is positively correlated with the three tax avoidance
measures and with environmental uncertainty, suggesting able managers are
less likely to engage in tax avoidance activities. In conclusion, the results
provide initial evidence supporting our hypotheses.
EMPIRICAL RESULTS
Panel A of Table 3 reports the clustered standard errors regression results of
Eq. (1) testing the first hypothesis (H1). In the regression model where the depen-
dent variable is GAAPETR, the coefficient on EU is 0.025 (p-value ¼ 0.020).
When CASHETR and CASHETR5 are the dependent variables, the coefficients
on EU are 0.036 (p-value ¼ 0.023) and 0.041 (p-value ¼ 0.025), respectively.
The negative and significant coefficients support H1 that environmental uncer-
tainty is negatively related to the effective tax rate, suggesting that firms engage
in more tax avoidance activities when faced with a more uncertain environment.
For the control variables, our three tax avoidance measures are significantly
and positively associated with firm size (SIZE) and return on assets (ROA), but
negatively associated with market-to-book ratio (MTB), loss carry forward
(NOL), directional change in loss carry forward (CHGNOL), property, plant
and equipment (PPE), research and development (RD), equity income
(EQINC), intangible assets (INTAN), and volatility of operating cash flows
(CASHVOL). These findings are consistent with general expectations and in
line with prior studies on tax avoidance. For example, Hope et al. (2013) find
effective tax rates are significantly positively associated with firm size and
return on assets, but negatively associated with market-to-book ratios, loss
carry forward, changes in loss carry forward, net property, plant and equip-
ment, research and development expenditures, and equity income.
According to the FASB Interpretation No. 48 (FIN 48, now ASC 740-10),
firms are required to disclose unrecognized tax benefits. Effective in 2006, ASC
740-10 requires firms to evaluate the likelihood of the realization of their tax posi-
tions using a two-step process. In the first step, a firm determines whether a posi-
tion has a more-likely-than-no chance of being realized upon examination by the
tax authority. If so, the firm recognizes the position and proceeds to the second
step. In the second step, the firm measures the amount of tax benefit that has a
greater than 50% likelihood of being realized and recognizes this amount. As
required by the ASC 740-10, the firm discloses this amount in a reserve account
known as unrecognized tax benefits (UTBs). UTBs capture the aggressive end of
the tax avoidance spectrum and have been used in prior studies on tax
Table 3. Environmental Uncertainty and Tax Avoidance.

Panel A: Dependent Variable ¼ Effective Tax Rates
Variables Dependent Variable of Tax Avoidance
GAAPETR CASHETR CASHETR5
Intercept 0.325 0.339 0.342

EU 0.025** 0.036** 0.041**
p-value 0.020 0.023 0.025
SIZE 0.002*** 0.006*** 0.001*
p-value 0.000 <.0001 0.086

LEV 0.002 0.039*** 0.011**
p-value 0.688 <.0001 0.032
MTB 0.004*** 0.008*** 0.006***
p-value <.0001 <.0001 <.0001
NOL 0.008*** 0.029*** 0.024***
p-value 0.000 <.0001 <.0001
CHGNOL 0.020*** 0.068*** 0.071***
p-value <.0001 <.0001 <.0001
ROA 0.163*** 0.114*** 0.080***
p-value <.0001 <.0001 <.0001
FI 0.472*** 0.200*** 0.051
p-value <.0001 <.0001 0.164
PPE 0.020*** 0.106*** 0.120***
p-value 0.000 <.0001 <.0001
RD 0.284*** 0.395*** 0.398***
p-value <.0001 <.0001 <.0001
EQINC 0.656** 0.385*** 0.315
p-value 0.021 0.008 0.269
INTAN 0.014* 0.052*** 0.070***
p-value 0.051 <.0001 <.0001
CASHVOL 0.020* 0.031** 0.033**
p-value 0.075 0.041 0.019
Industry YES YES YES
Year YES YES YES
Adj. R2 0.060 0.078 0.100
Obs. 27,594 27,594 27,594
Notes: This panel reports the regression results of estimating the relationship between environmental
uncertainty and tax avoidance. Three different proxies for tax avoidance (namely, GAAPETR, CASHETR,
and CASHETR5) are the dependent variables. All continuous variables (except the logged value of firm
size) are winsorized at the first and 99th percentiles each year before entering regressions. Refer to
Appendix A for variable descriptions. Year and industry indicators are included in all model specifications.
We employ standard errors estimation using the robust cluster technique (two-way clustering by firm and
by year) proposed by Petersen (2009). ***, **, and * denote the regression coefficient is statistically
significant at the two-tailed 1%, 5%, and 10% level, respectively.
Panel B: Dependent Variable ¼ Unrecognized Tax Benefits (UTBs)
Variables Estimate Pr > |t|
Intercept 0.010 <.0001

EU 0.003** 0.045
SIZE 0.000 0.524
LEV 0.004 0.182
MTB 0.001 0.194
NOL 0.001 0.140

CHGNOL 0.008* 0.088
ROA 0.031* 0.064
FI 0.091*** <.0001
PPE 0.011*** <.0001
RD 0.082*** <.0001
EQINC 0.091 0.152
INTAN 0.006* 0.051
CASHVOL 0.021* 0.095
Industry YES
Year YES
Adj. R2 0.132
Obs. 5,770
Notes: This table reports the regression results of estimating the relationship between environmental
uncertainty (EU) and tax avoidance. The proxy for tax avoidance, unrecognized tax benefits (UTBs), is the
dependent variable. All continuous variables (except the logged value of firm size) are winsorized at the first
and 99th percentiles each year before entering the regressions. Refer to Appendix A for variable
descriptions. Year and industry indicators are included in all model specifications. We employ standard
errors estimation using the robust cluster technique (two-way clustering by firm and by year) proposed by
Petersen (2009). ***, **, and * denote the regression coefficient is statistically significant at the two-tailed
1%, 5%, and 10% level, respectively.
avoidance. For example, Lisowsky, Mescall, Novack, and Pittman (2013) find
a significant and positive relationship between the ending balance in UTBs
and tax shelter participation. They further suggest that UTBs are a good sum-
mary measure of tax aggressiveness. Waegenaere, Sansing, and Wielhouwer
(2015) deem that ASC 740-10 reserve, namely UTB, is perhaps the best proxy
for tax aggressiveness.
Following prior studies (Hanlon, Maydew, & Saavedra, 2016; Hutchens &
Rego, 2013; Lisowsky et al., 2013; Rego & Wilson, 2012), we use UTBs in our
analysis as an additional tax avoidance measure. We collect the ending balance
of UTBs (TXTUBEND) from Compustat and regress UTBs, scaled by total
assets, on the main measure of environmental uncertainty (EU). A higher value
of UTBs indicates a higher level of tax aggressive. Hence, we expect a positive
relationship between UTBs and our EU measure. Our sample, with a total
of 5,770 observations, starts in 2006 because the ASC 740-10 became effec-
tive that year. Using UTBs as the dependent variable, Panel B of Table 3
reports the coefficient on EU is 0.003 (p-value ¼ 0.045), suggesting a signifi-
cant and positive relationship between environmental uncertainty and tax
aggressiveness.
To test whether managerial ability and environmental uncertainty impact
effective tax rate, we calculate the mean tax rate values within the quintiles
for both MARANK and EU. Managerial ability is expressed as reverse
ranked quintiles, i.e., a higher value means lower managerial ability. We first
sort and partition all firms into quintiles on the basis of EU. We then calcu-
late the mean tax rate value separately for each MARANK quintile across
each EU quintile. Table 4 reports tax rate for each EU and MARANK
quintile. Within each MARANK quintile in Panel A, GAAPETR shows a
decreasing pattern when EU increases from the lowest quintile to the highest
quintile. Specifically, in the third quintile of MARANK, GAAPETR
decreases from 0.331 for lowest EU quintile to 0.316 for highest EU quin-
tile, with t-stat of 2.94. A similar pattern is observed when we use
CASHETR to replace GAAPETR as shown in Panel B. In the third
MARANK quintile, CASHETR decreases from 0.281 for the lowest EU
quintile to 0.260 for the highest EU quintile. The difference is both econom-
ically and statistically significant. The CASHETR difference between the
highest EU quintile and the lowest EU quintile is 0.021 (0.021/0.281 ¼
7.5%), and the t-stat is 3.70. This indicates that there is a strong associa-
tion between EU score and tax rate, which is in line with the results in
Table 4.
Panel B of Table 4 reports that, within each quintile of EU, CASHETR
does not show a significantly decreasing pattern across MARANK quintiles
(with only one t-stat > 2.00). However, Panel C shows that, within each EU
quintile, CASHETR5 indicates a significantly decreasing pattern with the
increase of MARANK, consistent with the correlation results in Table 2
(i.e., the coefficient 0.105 relating EU to CASHETR5 is more significant
than the coefficient 0.062 relating EU to CASHETR). Considering Panels
B and C together, we conclude that the interplay of managerial ability and
corporate environment is more strongly associated with the long-run cash
effective tax rate than yearly cash effective tax rate, as long-run cash effec-
tive tax rate (CASHETR5) avoids year-to-year volatility in annual tax rates.
Next, we turn to multivariate analysis to further examine their relationships
in H2.
Table 5 reports the clustered standard errors regression results testing the
second hypothesis (H2). To ease the interpretation of results, the managerial
ability measure entering the regression is reverse ranked quintiles, i.e., a higher
value means lower managerial ability. Also, the value of EU is quintiles ranked
when entering the regression model of Eq. (2). Consistent with H1, the
Table 4. Tax Avoidance in Managerial Ability/Environmental Uncertainty

Quintile.
Panel A: GAAPETR with MARANK/EU
MARANK EU Score
Low 2 3 4 High High Low t-stat
Low 0.342 0.324 0.329 0.316 0.292 0.050 8.15

2 0.334 0.323 0.322 0.319 0.303 0.031 4.97
3 0.331 0.331 0.337 0.328 0.316 0.015 2.94
4 0.330 0.328 0.325 0.324 0.319 0.011 1.87

High 0.321 0.320 0.303 0.303 0.280 0.041 6.26
High Low 0.021 0.004 0.026 0.013 0.012
t-stat 4.47 1.12 4.67 2.50 2.01
Panel B: CASHETR with MARANK/EU
MARANK EU Score
Low 0.295 0.280 0.277 0.268 0.251 0.044 6.46

2 0.282 0.285 0.279 0.270 0.271 0.011 1.93
3 0.281 0.280 0.278 0.268 0.260 0.021 3.70
4 0.273 0.267 0.266 0.254 0.254 0.019 3.65
High 0.275 0.270 0.267 0.260 0.248 0.027 4.77
High Low 0.020 0.010 0.010 0.008 0.003
t-stat 3.16 1.89 1.91 1.76 0.98
Panel C: CASHETR5 with MARANK/EU
MARANK EU Score
Low 0.316 0.300 0.296 0.284 0.276 0.040 5.19

2 0.306 0.290 0.285 0.275 0.271 0.035 5.02
3 0.310 0.290 0.294 0.266 0.268 0.042 6.47
4 0.297 0.272 0.290 0.264 0.261 0.036 5.26
High 0.286 0.271 0.271 0.263 0.259 0.027 4.53
HighLow 0.030 0.029 0.025 0.021 0.017
t-stat 4.84 4.79 4.56 3.80 3.11
Note: This table presents the tax rate average in two-way quintiles based on managerial ability rank-
ing and environmental uncertainty ranking. We report the mean effective tax rate in each quintile
cell. The effective tax rate is GAAPETR in Panel A, CASHETR in Panel B, and CASHTER5 in
Panel C, respectively.
Table 5. Environmental Uncertainty and Tax Avoidance Moderating by

Managerial Ability.
Intercept 0.280 0.297 0.321

EU 0.002** 0.004** 0.003**
p-value 0.021 0.043 0.016
MARANK 0.002* 0.002* 0.002*
p-value 0.064 0.080 0.055
EU × MARANK 0.005*** 0.008*** 0.010***

p-value 0.001 0.001 0.001
SIZE 0.002*** 0.005*** 0.003**
p-value 0.005 <.0001 0.024
LEV 0.004 0.035*** 0.016**
p-value 0.218 0.007 0.020
MTB 0.004*** 0.007*** 0.006***
p-value <.0001 <.0001 <.0001
NOL 0.006*** 0.025*** 0.022***
p-value 0.002 <.0001 <.0001
CHGNOL 0.049*** 0.053*** 0.061***
p-value <.0001 <.0001 <.0001
ROA 0.157*** 0.106*** 0.040***
p-value <.0001 <.0001 0.079
FI 0.485*** 0.236*** 0.090**
p-value <.0001 <.0001 0.038
PPE 0.018*** 0.101*** 0.126***
p-value 0.005 <.0001 <.0001
RD 0.205*** 0.300*** 0.322***
p-value <.0001 <.0001 <.0001
EQINC 0.097 0.068 0.077
p-value 0.124 0.116 0.189
INTAN 0.014** 0.029*** 0.057***
p-value 0.039 <.0001 <.0001
CASHVOL 0.023* 0.029** 0.032**
p-value 0.084 0.024 0.019
Year YES YES YES
Adj. R2 0.062 0.079 0.102
Obs. 24,087 24,087 24,087
Note: This table reports the regression results estimating the moderating effect of managerial ability (MARANK) on
the relationship between environmental uncertainty and tax avoidance. Three different proxies for tax avoidance
(namely, GAAPETR, CASHETR, and CASHETR5) are the dependent variables. Both MARANK and EU in the
regressions are quintile ranks. All continuous variables (except the logged value of firm size) are winsorized at the
first and 99th percentiles each year before entering regressions. Refer to Appendix A for variable descriptions. Year
and industry indicators are included in all model specifications. We employ standard errors estimation using the
robust cluster technique (two-way clustering by firm and by year) proposed by Petersen (2009). ***, **, and * denote
the regression coefficient is statistically significant at the two-tailed 1%, 5%, and 10% level, respectively.
coefficients on EU are significantly negative across all three effective tax rates
(p-values < 0.05). The coefficients on reverse MARANK are significant and
negative across all three effective tax rates (p-values < 0.10), suggesting that
more-able managers are less tax aggressive. This is consistent with the argument
in Francis et al. (2015) that more-able managers who can better turn firm
resources into revenue spend more effort in normal business operations than in
tax avoidance activities.
The coefficients on the interaction of EU × MARANK are 0.005 (p-value
< 0.01), 0.008 (p-value < 0.01), and -0.010 (p-value < 0.01) for the models when
the dependent variables are GAAPETR, CASHETR, and CASHETR5, respec-
tively. The negative and significant coefficients on the interaction term (EU ×
MARANK) support the H2 that the relationship between environmental uncer-
tainty and effective tax rates strengthens (weakens) when a firm’s managerial
ability is low (high), suggesting that more-able managers can better mitigate
this relationship, relative to less-able managers.12
ROBUSTNESS CHECKS AND ADDITIONAL TESTS

Using Alternative Environmental Uncertainty Measure13
Prior studies (e.g., Snyder & Glueck, 1982; Tosi et al., 1973) suggest that tech-
nology volatility can be useful as an alternative measure of environmental
uncertainty. Technology input is measured as the ratio of the sum of research
and development expenditures and capital expenditures to total assets at the
firm level. We use the coefficient of variation (CV) of technology input to cap-
ture technology volatility. The formula to calculate CV of technology is
expressed below:
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
P 5
ðTi Tmean Þ2
5
i¼1
CVðT Þ ¼
Tmean
where Ti is a firm’s technology input in year i and Tmean is the mean of technol-
ogy input over a five-year period. A higher value of CV of technology indicates
a higher level of environmental uncertainty.
We collect additional data on research and development expenditures14
(XRD) and capital expenditures (CAPX) to calculate the alternative EU mea-
sure (EUTECH).15 Panel A of Table 6 reports the regression results using
EUTECH as the explanatory variable of interest where the dependent variables
are effective tax rates. The coefficient on EUTECH is 0.014 (p-value ¼ 0.041)
in the regression model where the dependent variable is GAAPETR. When the
Table 6. Alternative Environmental Uncertainty Measure and

Tax Avoidance.
Panel A: Dependent Variable ¼ Effective Tax Rates
Intercept 0.304 0.316 0.325

EUTECH 0.014** 0.025** 0.022**
p-value 0.041 0.036 0.019
SIZE 0.002** 0.003*** 0.001*

p-value 0.041 <.0001 0.094
LEV 0.001 0.038*** 0.011**
p-value 0.520 <.0001 0.029
MTB 0.004*** 0.007*** 0.005***
p-value <.0001 <.0001 <.0001
NOL 0.006*** 0.027*** 0.026***
p-value 0.002 <.0001 <.0001
CHGNOL 0.018*** 0.054*** 0.062***
p-value <.0001 <.0001 <.0001
ROA 0.184*** 0.124*** 0.128***
p-value <.0001 <.0001 <.0001
FI 0.461*** 0.193*** 0.050**
p-value <.0001 <.0001 0.015
PPE 0.027*** 0.100*** 0.120***
p-value <.0001 <.0001 <.0001
RD 0.334*** 0.338*** 0.411***
p-value <.0001 <.0001 <.0001
EQINC 0.735** 0.805** 0.369*
p-value 0.043 0.012 0.068
INTAN 0.020*** 0.061*** 0.076***
p-value 0.004 <.0001 <.0001
CASHVOL 0.022* 0.028** 0.030*
p-value 0.051 0.013 0.055
Year YES YES YES
Adj. R2 0.062 0.081 0.103
Obs. 27,594 27,594 27,594
Notes: This panel reports the regression results estimating the relationship between environmental uncertainty
(EUTECH) and tax avoidance. Three different proxies for tax avoidance (namely, GAAPETR, CASHETR, and
CASHETR5) are the dependent variables. All continuous variables (except the logged value of firm size) are
winsorized at the first and 99th percentiles each year before entering regressions. Refer to Appendix A for variable
descriptions. Year and industry indicators are included in all model specifications. We employ standard errors
estimation using the robust cluster technique (two-way clustering by firm and by year) proposed by Petersen (2009).
***, **, and * denote the regression coefficient is statistically significant at the two-tailed 1%, 5%, and 10% level,
respectively.
Panel B: Dependent Variable ¼ Unrecognized Tax Benefits (UTBs)
Variables Dependent Variable ¼ UTBs
Estimate Pr > |t|
Intercept 0.006 0.002

EUTECH 0.004** 0.029
SIZE 0.001** 0.016
LEV 0.004 0.103
MTB 0.0004 0.206

NOL 0.001 0.238
CHGNOL 0.008 0.103
ROA 0.039** 0.031
FI 0.094*** <.0001
PPE 0.011*** <.0001
RD 0.083*** <.0001
EQINC 0.042 0.333
INTAN 0.008** 0.041
CASHVOL 0.030** 0.017
Industry YES
Year YES
Adj. R2 0.141
Obs. 5,770
Notes: This table reports the regression results of estimating the relationship between the alternative measure of
environmental uncertainty (EUTECH) and tax avoidance. The proxy for tax avoidance, unrecognized tax benefits
(UTBs), is the dependent variables. All continuous variables (except the logged value of firm size) are winsorized at
the first and 99th percentiles each year before entering the regressions. Refer to Appendix A for variable
descriptions. Year and industry indicators are included in all model specifications. We employ standard errors
estimation using the robust cluster technique (two-way clustering by firm and by year) proposed by Petersen (2009).
***, **, and * denote the regression coefficient is statistically significant at the two-tailed 1%, 5%, and 10% level,
respectively.
dependent variable is CASHETR or CASHETR5, the coefficient on EUTECH

is 0.025 (p-value ¼ 0.036) or 0.022 (p-value ¼ 0.019), respectively. The nega-
tive and significant coefficients again support the hypothesis (H1) that environ-
mental uncertainty is negatively related to effective tax rates. This evidence
suggests that firms are more likely to engage in tax avoidance activities when
faced with more uncertain environments, consistent with our previous results in
the fourth section. Using UTBs as the dependent variable, Panel B of Table 6
reports the coefficient on EUTECH is 0.004 (p-value ¼ 0.029), suggesting a
significant and positive relationship between environmental uncertainty and tax
aggressiveness.
Two-stage Least Squares (2SLS) Regression Analysis
Although we find a positive relationship between environmental uncertainty

and tax avoidance, it is possible that some omitted time-variant variables are
correlated with both environmental uncertainty and tax avoidance, thereby
biasing our results. To mitigate the concern of endogeneity, we perform a 2SLS
analysis, following Jiraporn, Jiraporn, Boeprasert, and Chang (2014). This
analysis requires identifying an instrumental variable (IV) which is highly corre-
lated to a firm’s environmental uncertainty but does not influence firm perfor-
mance except through environmental uncertainty. Consistent with Jiraporn

et al. (2014), we use the average environmental uncertainty of the firms in the
same industry (using 2-digit SIC classification code). This variable is clearly
related to the environmental uncertainty of a given firm, but it does not relate
to the tax avoidance activities of a given firm. In the first stage of the 2SLS, we
estimate the instrumented environmental uncertainty using the average scores
of environmental uncertainty of firms in the same industry. We include all the
control variables, as well as the industry and year indicators. In the second
stage of the 2SLS regression, we use the instrumented values of EU from the
first stage as independent variables. We still use the same control variables in
the second stage regression.
Table 7 reports the 2SLS regression results for testing the hypothesis (H1).
For the relationship between EU and our three tax avoidance measures, the
first stage regression reports the mean EU is positively and significantly related
to individual EU (coefficient ¼ 1.191; p-value ¼ 0.020). The second stage model
shows a significant and negative relationship between instrumented EU and our
three tax avoidance measures: GAAPETR, CASHETR, and CASHETR5.
Specifically, when GAAPETR is the dependent variable, the second stage
model reports that the coefficient on the instrumented EU is negative (0.017)
and highly significant (p-value ¼ 0.045), suggesting that firms faced with uncer-
tain environment are likely to engage in more tax avoidance activities. The
same inference is drawn from the models when CASHETR and CASHETR5
are the dependent variables. Overall, the 2SLS analysis lends support to the
main results.
Other Additional Tests
Small Firms versus Large Firms

Zimmerman (1983) finds that firm size is positively related to a firm’s effective
tax rate, suggesting that smaller firms are more likely to engage in tax
avoidance activities. Mills et al. (1998) and Rego (2003) argue that firms enjoy
economies of scale in the tax planning arena. We conjecture that environmental
uncertainty has a stronger impact on smaller firms than on larger firms because
Table 7. Two-Stage Least Squares (2SLS) Regression Analysis.

Variables Stage 1 Stage 2 Stage 2 Stage 2
EU GAAPETR CASHETR CASHETR5
Intercept 0.021 0.302 0.319 0.325

EU_Mean 1.191**
p-value 0.020
EU (instrumented) 0.017** 0.025** 0.031**
p-value 0.045 0.027 0.020
SIZE 0.009*** 0.003*** 0.005*** 0.002**
p-value <.0001 <.0001 <.0001 0.045

LEV 0.030** 0.002 0.038*** 0.011**
p-value 0.015 0.264 <.0001 0.019
MTB 0.018*** 0.005*** 0.007*** 0.006***
p-value <.0001 <.0001 <.0001 <.0001
NOL 0.031*** 0.008** 0.022*** 0.023***
p-value <.0001 0.020 <.0001 <.0001
CHGNOL 0.029** 0.026*** 0.052*** 0.048***
p-value 0.020 <.0001 <.0001 <.0001
ROA 0.253*** 0.163*** 0.113*** 0.0726***
p-value <.0001 <.0001 <.0001 <.0001
FI 0.641*** 0.421*** 0.200*** 0.051*
p-value <.0001 <.0001 <.0001 0.072
PPE 0.008 0.020*** 0.106*** 0.122***
p-value 0.338 0.004 <.0001 <.0001
RD 0.445*** 0.284*** 0.390*** 0.392***
p-value <.0001 <.0001 <.0001 <.0001
EQINC 0.913* 0.651** 0.815** 0.321*
p-value 0.076 0.014 0.018 0.094
INTAN 0.256*** 0.014** 0.051*** 0.070***
p-value <.0001 0.019 <.0001 <.0001
CASHVOL 0.078*** 0.021* 0.026** 0.029*
p-value 0.001 0.071 0.034 0.055
Industry YES YES YES YES
Year YES YES YES YES
Adj. R2 0.080 0.061 0.079 0.101
Obs. 27,594 27,594 27,594 27,594
Note: This table presents the regression results estimating the tax effect of environmental uncertainty
(EU). To address endogeneity concerns, we employ IV-2SLS regressions. Refer to Appendix A for
variable descriptions. The dependent variable in Eq. (1) is EU. For the second-stage regression, we
use predicted raw EU as the explanatory variable. All t-statistics are calculated with two-way clus-
tered standard errors by firm and by year (Petersen, 2009). ***, **, and * denote the regression coef-
ficient is statistically significant at the two-tailed 1%, 5%, and 10% level, respectively.
larger firms have more resources and capabilities to operate in uncertain envir-
onments. Hence, the observed relationship should be stronger for smaller firms.
To further investigate this size effect, we evenly divide our sample into two sub-
samples (smaller firms vs. larger firms) using the median value of total assets by
year and perform the same regression analysis to the two subsamples.
Panel A of Table 8 shows that, when GAAPETR is the dependent variable,
the coefficients on EU are 0.022 (p-value ¼ 0.009) for smaller firms and
0.009 (p-value ¼ 0.072) for larger firms, respectively. Coefficient comparison
indicates that the coefficient on EU of smaller firms is significantly lower
(F-stat ¼ 50.11; p-value < 1%) than that of larger firms, suggesting that smaller
firms engage in more tax avoidance activities than do larger firms in more
uncertain environments. When CASHETR (CASHETR5) is the dependent var-
iable, Panel A reports the coefficients on EU are 0.026 (0.042) for smaller
firms and 0.014 (0.021) for larger firms, respectively. The above coefficients
are significant at the 5% level. Coefficient comparison indicates that the coeffi-
cients on EU of smaller firms are significantly lower than that of larger firms
when CASHETR is the dependent variable (F-stat ¼ 15.93; p-value < 1%), and
when CASHETR5 is the dependent variable (F-stat ¼ 20.16; p-value < 1%).
Thus, evidence from Panel A indicates that the relationship between environ-
mental uncertainty and that tax avoidance is stronger for smaller firms than for
larger firms. We reason that smaller firms engage in more tax avoidance than
larger firms in more volatile business environments.
High-Leverage Firms versus Low-Leverage Firms

Financial leverage indicates a firm’s financial sophistication (Mills et al., 1998).
Prior studies (e.g., Kim, Li, & Li, 2010; Lisowsky et al., 2013) suggest that firms
engaging in more tax avoidance issue more debt because tax avoidance reduces
the cost of debt. In other words, a firm with higher leverage has to pay more
interest and thus has incentive to engage in tax avoidance to gain tax savings.
Similarly, we argue that high-leverage firms have stronger incentives to engage
in tax avoidance16 when the environment becomes more uncertain. To further
investigate the leverage effect, we evenly divide our sample into two subsamples
(firms with higher leverage and firms with lower leverage) using the median
value of leverage by year and perform the same regression analysis on the two
subsamples.
Panel B of Table 8 shows that, when GAAPETR is the dependent variable,
the coefficients on EU are 0.022 (p-value < 0.0001) and 0.010 (p-value ¼
0.040) for high-leverage firms and low-leverage firms, respectively. Coefficient
comparison indicates that the coefficient on EU of firms with higher leverage is
significantly lower (F-stat ¼ 19.44; p-value ¼ 0.000) than that of firms with
lower leverage, suggesting that firms with higher leverage engage in more tax
avoidance activities than do firms with lower leverage in more uncertain
environments. When CASHETR (CASHETR5) is the dependent variable, the
Table 8. Environmental Uncertainty and Tax Avoidance: Cross-Sectional Tests.

Panel A: Small Firms vs. Large Firms
Variables GAAPETR CASHETR CASHETR5
Smaller Larger Smaller Larger Smaller Larger
Intercept 0.321 0.340 0.312 0.360 0.342 0.308

EU 0.022*** 0.009* 0.026*** 0.014** 0.042*** 0.021**
p-value <.0001 0.072 <.0001 0.022 0.001 <.0001
LEV 0.009 0.006 0.023*** 0.057*** 0.004 0.016**
p-value 0.245 0.218 0.003 <.0001 0.328 0.021
MTB 0.006*** 0.007 0.011*** 0.003*** 0.008*** 0.002***
p-value <.0001 0.229 <.0001 0.009 <.0001 0.005
NOL 0.013*** 0.008 0.044*** 0.010** 0.035*** 0.011***
p-value <.0001 0.194 <.0001 0.021 <.0001 0.008
CHGNOL 0.042*** 0.012** 0.099*** 0.061*** 0.075*** 0.064***
p-value <.0001 0.015 <.0001 <.0001 <.0001 <.0001
ROA 0.195*** 0.015 0.169*** 0.139*** 0.092*** 0.050
p-value <.0001 0.164 <.0001 0.001 <.0001 0.198
FI 0.348*** 0.418*** 0.075 0.297*** 0.276*** 0.196***
p-value <.0001 <.0001 0.346 <.0001 0.008 <.0001
PPE 0.013 0.017*** 0.091*** 0.133*** 0.115*** 0.131***
p-value 0.110 0.008 <.0001 <.0001 <.0001 <.0001
RD 0.336*** 0.237*** 0.384*** 0.395*** 0.391*** 0.368***
p-value <.0001 <.0001 <.0001 <.0001 <.0001 <.0001
EQINC 0.629 0.649** 0.689 0.918** 0.149 0.454
111
p-value 0.123 0.036 0.251 0.015 0.328 0.109
112
Panel A: Small Firms vs. Large Firms
Smaller Larger Smaller Larger Smaller Larger
INTAN 0.026* 0.015** 0.036** 0.043*** 0.055*** 0.063***

p-value 0.073 0.017 0.042 <.0001 <.0001 <.0001
CASHVOL 0.023* 0.028** 0.025** 0.029*** 0.020* 0.027**
p-value 0.052 0.043 0.028 0.004 0.051 0.016
Industry YES YES YES YES YES YES
Year YES YES YES YES YES YES
Adj. R2 0.074 0.065 0.092 0.093 0.101 0.109
Obs. 13,797 13,797 13,797 13,797 13,797 13,797
Coefficient comparison: EU of smaller of firms vs. EU of larger firms

F-stat 50.11 15.93 20.16
p-value <.0001 <.0001 <.0001
Panel B: High-Leverage Firms vs. Low-Leverage Firms
HENRY HUANG ET AL.

High LEV Low LEV High LEV Low LEV High LEV Low LEV
Intercept 0.299 0.304 0.312 0.300 0.309 0.294

EU 0.022*** 0.010** 0.028*** 0.016*** 0.037*** 0.028**
p-value <.0001 0.040 <.0001 0.009 <.0001 0.015
SIZE 0.005*** 0.004 0.009*** 0.005** 0.004*** 0.001
p-value <.0001 0.245 <.0001 0.012 0.008 0.521
MTB 0.004*** 0.003*** 0.011*** 0.005*** 0.008*** 0.004***
p-value <.0001 <.0001 <.0001 <.0001 <.0001 <.0001
NOL 0.007** 0.009*** 0.032*** 0.027*** 0.024*** 0.023***
p-value 0.027 0.008 <.0001 <.0001 <.0001 <.0001
CHGNOL 0.041*** 0.035 0.068*** 0.057*** 0.061*** 0.059***

p-value <.0001 0.200 <.0001 <.0001 <.0001 <.0001
ROA 0.191*** 0.078** 0.136*** 0.062* 0.100*** 0.014
p-value <.0001 0.046 <.0001 0.058 <.0001 0.180
FI 0.578*** 0.350*** 0.405*** 0.062 0.170* 0.114*
p-value <.0001 <.0001 <.0001 0.149 0.059 0.082
PPE 0.020** 0.017*** 0.090*** 0.103*** 0.088*** 0.129***
p-value 0.011 0.025 <.0001 <.0001 <.0001 <.0001
RD 0.292*** 0.293*** 0.375*** 0.331*** 0.368*** 0.398***
p-value <.0001 <.0001 <.0001 <.0001 <.0001 <.0001
EQINC 0.944*** 0.232 0.027 1.366*** 0.403 0.207
p-value 0.009 0.246 0.195 0.008 0.357 0.505
INTAN 0.029*** 0.005 0.068*** 0.036*** 0.082*** 0.052***
p-value 0.003 0.240 <.0001 0.0006 <.0001 <.0001
CASHVOL 0.024* 0.024* 0.025** 0.027** 0.030*** 0.024**
p-value 0.059 0.066 0.030 0.011 0.005 0.050
Industry YES YES YES YES YES YES
Year YES YES YES YES YES YES
Adj. R2 0.065 0.056 0.084 0.079 0.108 0.104
Obs. 13,797 13,797 13,797 13,797 13,797 13,797
113
114
Coefficient comparison: EU of high-leverage firms vs. low-leverage firms
F-stat 19.44 6.38 8.89

p-value 0.000 0.015 0.003
Panel C: Innovative Firms in Uncertain Environment
Intercept 0.325 0.339 0.350

EU 0.005** 0.006** 0.006**
p-value 0.027 0.048 0.046
INNOVATION 0.002** 0.002** 0.003**
p-value 0.038 0.041 0.040
EU × INNOVATION 0.009*** 0.011*** 0.008***
p-value <.0001 <.0001 <.0001
SIZE 0.003** 0.001 0.004***
p-value 0.028 0.193 0.041
HENRY HUANG ET AL.

LEV 0.009 0.025** 0.015**
p-value 0.106 0.024 0.015
MTB 0.002 0.004** 0.003*
p-value 0.352 0.011 0.076
NOL 0.003 0.020*** 0.018***
p-value 0.122 <.0001 0.001
CHGNOL 0.027*** 0.030*** 0.042***
p-value 0.005 <.0001 <.0001
ROA 0.005 0.040* 0.030
p-value 0.159 0.087 0.147
FI 0.423*** 0.162*** 0.041
p-value <.0001 <.0001 0.195

PPE 0.023** 0.108*** 0.117***
p-value 0.045 <.0001 <.0001
RD 0.284*** 0.429*** 0.382***
p-value <.0001 <.0001 <.0001
EQINC 0.598** 0.781*** 0.357*
p-value 0.046 0.007 0.098
INTAN 0.014** 0.056*** 0.067***
p-value 0.041 <.0001 <.0001
CASHVOL 0.023** 0.020* 0.019*
p-value 0.021 0.060 0.074
Year YES YES YES
Adj. R2 0.061 0.079 0.102
Obs. 27,594 27,594 27,594
Note: This table reports the regression results estimating the relationship between environmental uncertainty and tax avoidance under different cross-sec-
tional conditions. Panel A tests the effect of firm size, Panel B tests the effect of financial leverage, and Panel C tests the effect of corporate innovativeness.
Three different proxies for tax avoidance (namely, GAAPETR, CASHETR, and CASHETR5) are the dependent variables. All continuous variables are
winsorized at the first and 99th percentiles each year before entering regressions. Refer to Appendix A for variable descriptions. Year and industry indica-
tors are included in all model specifications. We employ standard errors estimation using the robust cluster technique (two-way clustering by firm and by
year) proposed by Petersen (2009). ***, **, and * denote the regression coefficient is statistically significant at the two-tailed 1%, 5%, and 10% level,
respectively.
115
coefficients on EU are 0.028 (0.037) for firms with higher leverage and
0.016 (0.028) for firms with lower leverage, respectively. The above coeffi-
cients are significant at the 5% level. Coefficient comparison indicates that the
coefficients on EU of firms with higher leverage are significantly lower than
that of firms with lower leverage when CASHETR is the dependent variable
(F-stat ¼ 6.38; p-value ¼ 0.015), and when CASHETR5 is the dependent vari-
able (F-stat ¼ 8.89; p-value ¼ 0.003). Thus, evidence from Panel B indicates that
the relationship between environmental uncertainty and tax avoidance is stron-
ger for firms with higher leverage. That is, higher leveraged firms engage in more
tax avoidance than do lower leveraged firms in more volatile environments.

The above findings are possibly inconsistent with the tax theory, which sug-
gests that debt incurs interest expense, which is deductible. Therefore, firms
with a greater reliance on equity may miss out on these deductions because the
cost of equity (dividends) is not tax deductible. Thus, firms that are highly lev-
eraged have less of a need to engage in other types of tax avoidance. Some stud-
ies support the above notion. For example, Graham, Lang, and Shackerlford
(2004) find that firms with large employee stock option deductions also engage
in aggressive tax avoidance activities and the impact of employee options on
tax avoidance activities also affect debt policy. The evidence supports the
notion that managers trade off debt interest deductions with other forms of
deductions. Using 44 tax shelter firms, Graham and Tucker (2006) find that
these shelter firms do not appear under-leveraged (once shelters are considered),
compared to their matched sample.
Corporate Innovation
Innovation has received tremendous attention. Gao, Yang, and Zhang (2016)
document that innovative firms are more likely to engage in tax avoidance
activities, suggesting that firm innovation is an important determinant of tax
avoidance. Whether innovative firms in uncertain environments engage in more
or less tax avoidance is an interesting question that has not been examined pre-
viously. For completeness, we perform an additional test investigating the tax
avoidance behavior of innovative firms in uncertain environments. Firm
(technological) innovation is risky activity (e.g., extremely expensive, time-
consuming, with a very high failure rate). R&D expenditures are positively
related to the uncertainty of future benefits from those investments (Kothari,
Leone, & Laguerre, 2002). Patents and R&D could benefit from both tax
reduction and tax deferral strategies (Wilson, 2009). We follow Hirshleifer,
Hsu, and Li (2013) to measure innovation efficiency as the number of patents
granted scaled by R&D capital.17 We interact innovation efficiency with
environmental uncertainty to examine whether innovative firms in uncertain
environments are more likely associated with tax reduction. Our sample
includes 6,328 firm-year observations with nonzero levels of innovation
efficiency. The remaining 21,266 observations are treated as noninnovative

firms (i.e., the value of innovation for these firms is taken as 0).
Panel C of Table 8 shows that, when GAAPETR is the dependent variable,
the coefficient on the interaction term of EU × INNOVATION is 0.009
(p-value < 1%). When CASHETR (CASHETR5) is the dependent variable, the
coefficients on EU × INNOVATION is 0.010 (0.008), and the coefficients
are significant at the 1% level. Thus, evidence from Panel C indicates that the
relationship between environmental uncertainty and tax avoidance is stronger
for firms that are innovation efficient. In other words, innovative firms engage
in more tax avoidance or enjoy more taxation benefits as typically these firms
operate in more uncertain and competitive business environments.
CONCLUSION
Understanding the determinants of tax avoidance is an important research area
(Hanlon & Heitzman, 2010). Relatively few studies have examined how a firm’s
external environment affects its tax avoidance activities. In this study, we examine
the relationship between environmental uncertainty and firm-level tax avoidance
activities. We hypothesize that higher environmental uncertainty leads to more tax
avoidance activities, reflected in lower effective tax rates. We further conjecture
that managers with greater ability better mitigate the relationship between envi-
ronmental uncertainty and tax avoidance, as more-able managers are less opportu-
nistic and may engage in fewer tax-avoidance behaviors. Our results are consistent
with these hypotheses. We also perform various additional tests including alterna-
tive measures of tax avoidance and environmental uncertainty. These additional
tests still provide consistent evidence supporting our hypotheses. Moreover, we
find that the relationship between environmental uncertainty and tax avoidance
activities are stronger in small, highly leveraged, and innovative firms.
This study has the following limitations. First, it is difficult to measure man-
agerial ability because it is multi-dimensional. The managerial ability index
scores by Demerjian et al. (2012) are an approximate measure of management
performance. More-precise measures of management performance may yield
stronger results. Second, our sample only consists of public firms. Whether our
conclusions hold in private firms remains unknown. Readers need to exercise
caution when generalizing the conclusions. The above issues can be investigated
in future studies.
NOTES
1. The concept of environmental uncertainty refers to the degree, or variability, of

change that characterizes environmental activities relevant to an organization’s opera-
tions such as the unpredictability of the actions of the customers, suppliers, competitors
and regulatory groups to which probabilities cannot be attached because of their con-
stant change (Dess & Beard, 1984; Drago, 1998; Ghosh & Olsen, 2009). The notion of
environmental uncertainty is distinct from the concept of firm risk in prior tax studies.
For example, Guenther, Matsunaga, and Williams (2016) use the standard deviation of
monthly stock returns to measure firm risk.
2. We use the clustered standard errors regression (two-way clustering by firm and
by year) as the main regression model in our study.
3. Since the passage of the Financial Accounting Standards Board (FASB)’s
Interpretation No. 48 (Accounting for Uncertainty in Income Taxes), several recent papers
measure firms’ tax aggressiveness using the magnitude of their uncertain tax benefits
(e.g., Rego & Wilson, 2012; Lisowsky, Robinson, & Schmidt, 2013).
4. Ghosh and Olsen (2009) argue that, unlike sales, technological characteristics are
more of a response by management to the external environment as opposed to a direct

measure of environmental uncertainty. We next discuss the two measures of environmen-
tal uncertainty.
5. Our environmental uncertainty measure is similar to that (i.e., volatility of operat-
ing cash flows) in McGuire et al. (2014). To mitigate the above similarity concern, we
include the volatility of operating cash flows as a control variable.
6. It is likely that the uncertainty measure in Gallemore and Labro (2015) is some-
what similar to our uncertainty measure. In our study, we closely follow Ghosh and
Olsen (2009) to calculate environmental uncertainty based on the sales volatility over the
prior five-year period. We acknowledge the similarity between our environmental uncer-
tainty measure and the uncertainty measure in Gallemore and Labro (2015).
7. Our results are different from the findings in Gallemore and Labro (2015). We
argue that, despite the similarities between the two uncertainty measures, our uncertainty
measure is still different from that in Gallemore and Labro (2015). For example, we cal-
culate environmental uncertainty using the prior five-year data while Gallemore and
Labro (2015) use the prior year’s data. Our uncertainty measure is a continuous variable
in the main analysis, while the uncertainty variable in Gallemore and Labro (2015) is a
dummy variable.
8. Tax planning has two prongs minimizing tax expense and minimizing tax risk
or tax uncertainty. Reducing tax expense involves tax strategies that are less certain and
may expose the firm to greater uncertainty regarding future tax payments (caused by
potential penalties and interest assessed by taxing authorities). Hence, it is possible that
firms in an already volatile environment may impose a greater premium on avoiding
additional tax risk (tax uncertainty) through their tax planning strategies as opposed to
minimizing tax payments.
9. There is no consensus that tax avoidance is opportunistic in accounting literature.
10. It is highly possible that more-able managers engage in more tax avoidance, relative
to less-able managers, as more-able managers are more capable of doing opportunistic
practice. Prior research on managerial ability discusses the link between managerial ability
and the level of opportunistic behavior and the evidence does not support a strong link.
For example, Sun (2016) discusses the possibility of a higher level of opportunistic behav-
ior of more-able managers, and he finds that it is the ability to manage the firm that drives
the managerial ability, not the ability to engage in opportunistic behavior.
11. CASHETR may overstate a firm’s tax aggressiveness. In addition, this measure
may not reflect items such as settlement of government audits or estimated tax payments
for future years.
12. As a robustness check, in a separate analysis we use the long-term MARANK,
which equals average managerial ability score for the last three years. The regression
results (untabulated for reason of brevity) remain qualitatively the same.
13. Based on prior research (e.g., Ghosh & Olsen, 2009), there are three measures for
environmental uncertainty, namely sales volatility, earnings volatility, and technology
volatility. We use both sales volatility and technology volatility in our study. The reason
that we do not use earnings volatility is because earnings can be affected by many
factors, such as operating expenses, taxes, interest expenses, and etc. Hence, sales are a
relatively clean variable, compared to earnings. As a robustness check, we repeat our
regression analysis using earnings volatility and still obtain similar results.
14. Consistent with many prior studies, we assume that R&D expenditures are zero
when the data is missing.
15. This measure uses variable (i.e., R&D) that are associated with specific tax poli-
cies, which may affect the dependent variable in our analysis.
16. Other studies (e.g., Shevlin, Urcan, & Vasvari, 2013) find evidence supporting the
substitution between leverage and tax avoidance.
17. Hirshleifer et al. (2013) also use another innovation efficiency measure: the
adjusted patent citations scaled by R&D expenses. This measure is calculated as the
number of adjusted citations per dollar of five-year cumulative R&D expense. Citationt
is the technology category adjusted number of citations received in year t by the patents
granted to the firm in previous five years (from year t5 to year t1, inclusive). The
method for adjusting citations follows Gu (2005) and Pandit, Wasley, and Zach (2011).
RDSt is defined as R & Di;t3 þ R&Di;t4 þ R&Di;t5 þ R&Di;t6 þ R&Di;t7 . The three-
year gap between RDSt and Citationt is the average two-year lag from patent application
to patent grant plus one-year allowance for the patents granted in year t 1 to receive
citations in year t. Our results for this cross-sectional test remain essentially the same
whether the innovation efficiency is patent-based or citation-based.
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APPENDIX A: VARIABLE DEFINITIONS
Research variables:
GAAPETR ¼ Total tax expense divided by pre-tax book income less special items.
CASHETR ¼ Total cash tax divided by pre-tax book income less special items.
CASHETR5 ¼ Total cash tax over a five-year period divided by pre-tax book income less special items
over the same five-year period.
UTBs ¼ Unrecognized tax benefits (TXTUBEND) divided by total assets in FIN 48, available
after 2006.
EU ¼ Environmental uncertainty, calculated as the coefficient of variation (CV) of sales

(scaled by total assets) to capture environmental uncertainty. The formula is expressed
rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
P5
ðSi Smean Þ2
5
i¼1
below:CVðSi Þ ¼ Smean .
EUTECH ¼ An alternative measure of environmental uncertainty, calculated as the coefficient of

variation (CV) of the ratio of research and development expenditures (XRD) and
capital expenditures (CAPX) to total assets (AT) to capture environmental uncertainty.
rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
P5
ðTi T mean Þ2
5
i¼1
The formula is expressed below:CVðTi Þ ¼ Tmean .
MASCORE ¼ Managerial ability score in Demerjian et al. (2012).
MARANK ¼ Quintile rankings of managerial ability score in Demerjian et al. (2012).
Control variables:
SIZE ¼ The natural log of market value (CSHO × PRCC_F).
LEV ¼ Total liabilities (LT) divided by lagged total assets (AT).
INNOVATION ¼ Innovation efficiency, indicated by the number of patents generated by each dollar of
R&D capital (RDC) (Hirshleifer et al., 2013). Patentt is the number of patents granted
in year t. RDCt is defined as the five-year cumulative R&D expenses assuming an
annual depreciation rate of 20% in fiscal year ending in year t2, i.e.,
RDCt ¼ R&Di;t2 þ 0:8 × R&Di;t3 þ 0:6 × R&Di;t4 þ 0:4 × R&Di;t5 þ 0:2 × R&Di;t6 .
The two-year gap between RDCt and Patentt is the average time lag (two years) from
patent application to patent grant.
MTB ¼ The ratio of market value (CSHO × PRCC_F) to book value (CEQ).
NOL ¼ An indicator variable equal to 1 if loss carried forward (TLCF) is negative at the
beginning of year t, 0 otherwise.
CHGNOL ¼ The change in a firm’s tax loss carry forward (TLCF) from prior year to current year,
scaled by lagged total assets (AT).
Appendix A. (Continued )
Control variables:
ROA ¼ Net operating income (NI) divided by lagged total assets (AT).
FI ¼ Foreign income (PIFO) divided by lagged total assets (AT), 0 if PIFO is missing.
PPE ¼ Net property, plant and equipment (PPENT) divided by lagged total assets (AT).
RD ¼ Research and development expenditures (XRD) divided by lagged total assets (AT), 0
if XRD is missing.
EQINC ¼ Equity income (ESUB) divided by lagged total assets (AT).
INTAN ¼ Intangible assets (INTAN) divided by lagged total assets (AT).
CASHVOL ¼ Standard deviation of cash flow from operations (OANCF XIDOC) divided by total
assets (AT) over five years.

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Advances in Taxation

Environmental Uncertainty and Tax Avoidance

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Henry Huang, Li Sun and Joseph Zhang

This paper examines the relationship between environmental uncertainty and

Advances in Taxation, Volume 24, 83124

environmental uncertainty, managers often use their flexibility and discretion to

discretionary accruals when faced with a more volatile environment. In sum-

that more-able managers mitigate the above negative relationship. We show

LITERATURE REVIEW AND HYPOTHESIS

Environmental uncertainty is defined as the variability of change that charac-

Olsen (2009) explore the impact of environmental uncertainty from an

tax planning in a volatile environment. Hanlon and Heitzman (2010) suggest

ing tax avoidance activities.

If a more volatile environment causes more organizational planning activi-

H1: Environmental uncertainty is positively related to tax avoidance.

implement better strategies to adapt to the environment, instead of engaging

calculate CV of sales by year and industry (using two-digit SIC code).

Measures of Tax Avoidance

Total income tax expense ðTXT; 16Þ

Cash tax paidðTXPD;317Þ

Σ Cash tax paid ðTXPD;317Þ

Measure of Managerial Ability

Demerjian et al. (2012) develop a summary measure of managerial ability, a

TAXAVOIDi;t ¼ β0 þ β1 EUi;t þ β2 SIZEi;t þ β3 LEVi;t þ β4 MTBi;t þ β5 NOLi;t

In Eq. (1), the dependent variable (TAXAVOID) represents each of the

TAXAVOIDi;t ¼ β0 þ β1 EUi;t þ β2 MARANKi;t þ β3 EUi;t × MARANKi;t

Sample Selection and Descriptive Statistics

From Compustat we obtain financial statement data, which includes total

Table 1. Simple Statistics and Sample Distribution.

GAAPETR 27,594 0.324 0.151 0.261 0.340 0.382

Year # of Percent of Cumulative Year # of Percent of Cumulative

1993 946 3.43 3.43 2004 1,402 5.08 52.83

1997 1,356 4.91 21.59 2008 1,397 5.06 74.80

Panel C: Sample Distribution by Industry

SIC-2 Description Obs. % SIC-2 Description Obs. %

01 Agricultural Crops 61 0.22 40 Railroad 119 0.43

SIC-2 Description Obs. % SIC-2 Description Obs. %

28 Chemicals 1,742 6.31 72 Personal Services 135 0.49

33 Primary Metal 474 1.72 79 Amusement 231 0.84

HENRY HUANG ET AL.

avoidance measures (namely, GAAPETR, CASHETR, and CASHETR5) with

Table 3. Environmental Uncertainty and Tax Avoidance.

Variables Dependent Variable of Tax Avoidance

GAAPETR CASHETR CASHETR5

Intercept 0.325 0.339 0.342

p-value 0.000 <.0001 0.086

Variables Estimate Pr > |t|

Intercept 0.010 <.0001

NOL 0.001 0.140

Table 4. Tax Avoidance in Managerial Ability/Environmental Uncertainty

Low 2 3 4 High High Low t-stat

Low 0.342 0.324 0.329 0.316 0.292 0.050 8.15

4 0.330 0.328 0.325 0.324 0.319 0.011 1.87

Panel B: CASHETR with MARANK/EU

Low 2 3 4 High High Low t-stat

EU × MARANK 0.005* 0.008* 0.010***

SIZE 0.002 0.003* 0.001*

INTAN 0.026* 0.015 0.036 0.043* 0.055* 0.063***

CHGNOL 0.041* 0.035 0.068* 0.057* 0.061* 0.059***