Taxes and Earnings Management: Evidence from the Tax Cuts and Jobs Act of 2017

Abstract

We examine the influence of corporate income taxes on earnings management. We predict and find that corporate income taxes represent a significant friction in the level of discretion used in financial reporting decisions. Using the Tax Cuts and Jobs Act of 2017 (TCJA) as an exogenous shock to corporate tax rates, we observe a significant change in pretax earnings management following the passage of the TCJA. Consistent with theoretical predictions, we observe opposing changes in pretax earnings management conditional on the pre-TCJA level of discretion and capital market pressure. Additionally, we observe a reduction in non-conforming discretionary tax planning following the TCJA. Finally, we provide evidence that debt contracting provisions in new loan agreements were revised to account for anticipated changes in financial reporting incentives.