In the complex realm of corporate taxation, tax audits play a crucial role in influencing how companies deal with their tax planning strategies. The influence of these audits is substantial, yet a comprehensive understanding of their economic implications remains elusive, primarily due to the lack of detailed public data. Although tax audits are inherently negative news to firms, studies that examine the negative firm-level consequences of tax audits are scarce. Tax authorities, including the IRS, do not disclose which firms they audit and when. Given this, it has been empirically challenging to draw large-sample evidence on the heterogeneous economic effects of such audits.
In this study, we develop a novel firm-level measure of corporate tax audits from public corporate disclosures using some recent advances in natural language processing. We then provide comprehensive economic consequences of corporate tax audits. We confirm that tax audits reduce firms’ tax avoidance on average at the firm level and that such an effect tends to persist even after the audits are concluded. On the other hand, we find that firms experience some negative economic consequences during and after-tax audits. During tax audits, tax authorities may challenge firms’ tax planning vehicles and, therefore, firms face high informational uncertainty regarding future tax settlements. This increased operational uncertainty translates into an increase in stock return volatility. Furthermore, theory suggests that an increase in return volatility leads to an increase in the cost of capital. We find real effects consistent with the theory. Firms tend to curtail investments during, and after, tax audits and reduce new debt issuance after tax audits.
The Critical Role of Tax Audits in Corporate Taxation
The impact of tax audits on corporate behavior, particularly in tax planning and compliance, is profound. Surveys, including a notable one conducted by Graham et al. in 2014, reveal that a significant number of executives view the risk of detection by tax authorities as a decisive factor in their tax planning strategies. Our analysis shows that nearly three-quarters of U.S. firms disclosed information about their current tax audits in their 10-K filings in 2021, mainly highlighting the potential adverse impact of audit settlements on future earnings. Such widespread disclosure emphasizes the pivotal role of tax audits in corporate governance and financial decision-making.
Challenges in Understanding Tax Audits
Despite their importance, fully understanding the economic implications of tax audits at the firm level poses a considerable empirical challenge. The main obstacle is the lack of detailed public data, as tax authorities, including the IRS, generally do not share specific audit information. This lack of data has led researchers to rely on aggregate measures, such as IRS asset-size-group audit probabilities, or indirect measures, including the number of EDGAR downloads by the IRS, to gauge the attention of tax authorities. However, these proxies often fall short in capturing the nuanced and time-sensitive nature of tax audits.
The asset-size-group probabilities are the proportion of terminated audits of a given asset-size group each year. This data, although released by the IRS, provides audit probabilities at the group level and ignores substantial differences among firms in the same size group. The IRS attention proxy, the number of 10-K filing downloads by the IRS, captures how much attention the IRS pays to each firm. Although it is a firm-level measure, it is an indirect proxy of audits, and one cannot guarantee whether and when the audits happen.
An Innovative Approach to Measuring Tax Audits
To bridge this gap in measuring tax audits, our study introduces a novel firm-year-level tax audit measure based on public narrative disclosures. This method marks a significant advancement for two reasons. First, it allows a detailed and timely analysis of tax audits at the individual firm level, which was previously unachievable with the available data. Second, this measure sheds light on the varied impacts of tax audits across different firms, offering insights that are often overlooked in broader aggregate analyses.
To compute our measure, we rely on the most advanced large language model so far – GPT4.0 from OpenAI. This advanced technology was instrumental in analyzing the complex, often repetitive language used in corporate tax-audit-related disclosures. Since tax-audit-related disclosures are largely boilerplate, capturing the subtle changes in firms’ language use using traditional keyword-based approaches is difficult. Our approach successfully parses tax-audit-related information from corporate disclosures, which, otherwise, would have been prohibitively costly to obtain. Our measure is positively correlated with previously used tax audit measures yet exhibits significant firm-level variation. Most importantly, we observe substantial time-series variation even within a single firm.
Notes. These figures show the correlation between our firm-level tax audit measure and the IRS’ asset-size-group-level tax audit probabilities. We can see that the two measures are almost perfectly correlated.
Utilizing the extensive variation and accuracy of our measurement, we find that, ceteris paribus, firms with high tax uncertainty, foreign income, low profitability, and high R&D intensity are more likely to be audited by tax authorities.
Key Insights from the Study
Our research provides several critical findings about the economic consequences of corporate tax audits.
Effective Deterrence Against Tax Avoidance: We confirm that tax audits serve their primary purpose in reducing firms’ tax avoidance activities, a finding that aligns with earlier research but is now substantiated at a more granular firm level. More importantly, we show that such an effect persists for at least three years from audit initiations. Firms tend to maintain lower levels of tax avoidance even after the conclusion of audits, indicating a prolonged influence of these audits on corporate tax behavior.
Unintended Economic Consequences: The research also uncovers some unintended negative economic consequences of extensive audits. These include increased operational uncertainty and impacts on investment decisions, highlighting the complex interplay between tax regulation and corporate strategy. Specifically, we show that increased operational uncertainty induced by tax audits translates into increased stock return volatility. As a result, firms curtail their investment and reduce new debt issuance following tax audits.
Notes. These figures show the time-trend of tax avoidance (cash effective tax rate, upper left), stock return volatility (upper right), investment (lower left), and debt issuance (lower right). T=0 denotes audit initiations. We set t=-2 to be zero and plot the relative changes. We observe an increase in cash effective tax rates (lower tax avoidance), an increase in stock return volatility, a decrease in investment, and a decrease in debt issuance.
Macroeconomic Impacts: At a macroeconomic level, the intensity of tax audits in a particular state correlates with lower investment levels, higher unemployment rates, and slower GDP growth. These findings suggest that tax audits can have a ripple effect on local economies, influencing a range of economic indicators.
Understanding the Stock Market’s Response to Tax Audits
Lastly, we examine how the stock market reacts to firms undergoing tax audits. We find a decrease in abnormal returns around the filing dates when firms underwent audits. This trend suggests that the market responds negatively to the uncertainty and potential financial implications of ongoing audits. Such negative reactions are not short-lived, and we continue to observe a continuing negative trend in abnormal returns over a 30-day period from the information release.
Notes. This figure shows cumulative abnormal market returns from the filing date. The dotted line represents firms that are currently undergoing tax audits and the solid line represents firms that are not. We observe a stark decreasing trend in cumulative abnormal returns for those who disclose that they are under tax audits.
Contributions to the Field and Future Research Directions
This study makes several key contributions to corporate taxation and finance. By providing a novel firm-level measure of tax audit derived from publicly available sources, it opens up new research opportunities in this area. The insights into the economic consequences of tax audits, both at the firm and macro levels, offer a comprehensive understanding of the impact of these audits. Additionally, by identifying the authority behind each audit, the study provides insights into the relative effectiveness of audits conducted by various tax authorities, including state-level and foreign entities.
Furthermore, we believe that our findings will be of interest to policymakers. We show some preliminary evidence tax audits fulfill their primary purpose but at some obvious costs. Looking ahead, further macroeconomic welfare analysis around corporate tax audits is required.
This post was adapted from their paper, “Economic Footprints of Tax Audits: A Generative AI-Driven Approach,” available on SSRN.
Ga-Young Choi is a Lecturer (Assistant Professor) in Accounting at the Bayes Business School of the City, University of London.
Alex Kim is a Ph.D. student at the Booth School of Business of the University of Chicago.
