The impact of book-tax conformity on reporting and investment behaviour

We examine, in a strategic tax-compliance model, how higher book-tax conformity affects firms' investment and tax reporting, and how these effects influence tax compliance and tax revenue. In this model, a firm decides on investment to affect expected cash flows, which are – after realisation – publicly observable in a financial statement, and files a tax report that is compliant or non-compliant. As book-tax conformity links financial statements to tax reports, financial statements provide information on firms' tax compliance. After observing the financial statement and the tax report, a strategic tax authority decides on audit. We show that, depending on realised cash flows, non-compliant tax reporting increases or decreases in book-tax conformity. For a low financial statement, higher book-tax conformity indicates that a low tax report is compliant with high probability. Therefore, audit incentives decrease, and non-compliant tax reporting increases. In contrast, for a high financial statement, non-compliant tax reporting decreases in book-tax conformity because book-tax differences become more informative to the tax authority. As higher book-tax conformity increases firms' expected tax payments from high financial statements, it reduces the marginal benefit of investment, thereby decreasing investment. In sum, higher book-tax conformity increases or decreases tax revenue and after-tax profits.