Taxpayer Behavior Under Audit Certainty

Abstract

This study uses a confidential dataset of firms assigned to the Internal Revenue Service (IRS)’s Coordinated Industry Case (CIC) program to examine the effect of audit certainty on taxpayer behavior. We first model the determinants of assignment to the program. Though the ability and incentive to avoid taxes are related to CIC assignment, we find that the IRS targets firms primarily based on size and complexity. We then test whether audit certainty has a significant effect on taxpayers’ initial filing liability (a deterrence effect), total filing liability (combined effect of deterrence and enforcement), or tax reserves (expected future tax payments associated with positions claimed in the current year). Results suggest that audit certainty alters managers’ expectations regarding future tax payments but does not have significant deterrence or enforcement effects relative to the IRS’s standard selection and audit process for large corporations not included in the CIC program. Our paper provides new empirical evidence on the strategic game between the taxpayer and the tax authority and has important implications for tax authorities as they consider the costs and benefits of expensive certain audit programs.