What Turns the Taxman On? The Effect of Tax Aggressiveness and Voluntary Audit on Adjustments to the Tax Returns of Private Companies

Using a large proprietary data set from the internal records of the Finnish Tax Administration for the fiscal year 2011, we examine the factors that trigger adjustments by the tax authority to the taxable income reported by around 25,000 small private companies. Using that data, we develop a new direct measure of tax aggressiveness and introduce the direct and indirect effects of external audit into the tax aggressiveness literature, whilst avoiding the classic endogeneity problem. We hypothesize and find that being tax aggressive increases the likelihood of the tax authority not accepting taxable income as reported, whereas having a voluntary audit with an unqualified audit opinion decreases it. We also find that an unqualified audit opinion moderates the positive effect of tax aggressiveness on the likelihood of the tax authority making adjustments. While these findings are statistically significant when tax aggressiveness is measured by the book-tax difference (non-taxable revenues less non-tax deductible expenses) reported in the company's tax return, they are insignificant when measured by the conventional metric of book-tax difference based on publicly available financial statement data. The main results are insensitive to whether the full sample is used or a balanced sample based on propensity score pairing of tax-adjusted firms with their non-adjusted counterparts. The robustness tests show that our results are qualitatively unaffected by the modifications made to the variable definitions and sample composition