Taxes and Audit Quality

Abstract

The effects of taxes have been discussed in almost every decision context in the extant literature, but the relationship between taxes and auditing has amazingly merited little attention. We explore the relationship between audit effort, audit quality and taxes from the perspective of both auditors and the public using an analytical research model. The analysis provides evidence that even symmetric taxes significantly influence audit effort and audit quality when auditors’ risk aversion is considered. While taxes do not influence audit effort monotonically, audit quality generally increases with decreasing tax rates. Hence, taxes may interfere with legislators’ efforts to improve audit quality. Additionally, we show that high quality audits should be a matter of public concern because the public is damaged whenever a party unfairly remains untaxed. Therefore, a socially optimal amount of audit effort exists. We derive a mandate- and auditor-specific liability limitation to achieve a socially optimal level of audit effort.