Tax Avoidance and Financial Statement Readability

Abstract

This paper examines whether managers of firms that engage in high levels of tax avoidance (TA) strategically reduce their financial statement readability (FSR) to mitigate the risk of exposing their TA strategies. On average, results are inconclusive, but mainly hold in the sample of firms with low effective tax rates (i.e., high TA levels). Specifically, focused on firms with above-industry-median TA, the panel regression results show a negative relation between TA and FSR, and the difference-in-differences analysis, based on the “Check-the-Box” regulation in 1997 that exogenously increases tax planning opportunities, suggests the negative impact of TA on FSR is likely causal. The relationship is stronger for firms faced with a greater likelihood of tax audit ex ante, firms in industries with a higher tax risk, and firms with a larger institutional ownership. The evidence adds to our understanding of the influence of corporate TA on financial disclosures.

Keywords: tax avoidance; financial statement readability; tax audit risk

JEL Classification: G18; G21; H26; M41