What Turns the Taxman On? Tax Aggressiveness, Financial Statement Audits and Tax Return Adjustments in Small Private Companies

Abstract

This study examines the effect of tax aggressiveness and voluntary audit of the financial statements on the likelihood of tax adjustments in small private companies. We provide evidence that (1) tax aggressiveness increases the likelihood of the tax authority not accepting taxable income as reported, whereas (2) voluntary audit decreases it. To derive our hypotheses, we build a theoretical stochastic model explaining tax authority’s reactions to bias and noise in tax returns and how these two relate to tax aggressiveness and voluntary audit. In our empirical tests of the hypotheses we use a large proprietary data set comprising internal records of the Finnish Tax Administration for the fiscal year 2010 combined with data on the taxable income reported by around 19,500 small private companies. Our results show that while the findings on tax aggressiveness are significant when measured with the book-tax difference using proprietary tax return data from the Tax Administration, they are insignificant when based on the conventional tax aggressiveness measure of book-tax difference derived from publicly available financial statement data. Our paper contributes to the literature by being the first to document the effects of tax aggressiveness and voluntary audit on tax return adjustments of small private companies.