The Effect of Tax Enforcement on Managers’ Self-Dealing: Evidence from Insider Trading

Abstract

This study examines the effect of tax enforcement on informed trading by corporate insiders. Building on prior work suggesting that the tax authority can discipline managerial misconduct (Dyck and Zingales 2004; Desai, Dyck, and Zingales 2007), we hypothesize that the increased scrutiny from an IRS audit raises insiders’ perceived risk of detection, who respond by reducing their trading activity while the firm is under audit. Using a novel, firm-specific measure to identify firms undergoing IRS audits, we find evidence consistent with our prediction. Further, we find that the deterrence effect is stronger among tax audits in which the IRS downloads SEC Form 4 filings (where insiders report their trades). We also find that the reductions in insider trading are most pronounced for the top 5 officers of the firm, are stronger when alternative monitoring channels are relatively weak, and that opportunistic trading is reduced but there is no effect on routine trading. Overall, our findings provide direct evidence that heightened scrutiny from tax enforcement serves as an effective monitoring mechanism and reduces the ability of insiders to profit from informed trading.