The Role of IRS Monitoring in Equity Pricing in Public Firms*

Abstract

We analyze the importance of Internal Revenue Service (IRS) monitoring to equity pricing in U.S. public firms. Our strong, robust evidence from large samples implies that equity financing is cheaper when the threat of an IRS audit is higher, enabling investors to learn more about the firm. Reflecting its first-order economic impact, our coefficient estimates translate into the cost of equity capital falling, on average, by 58 basis points when the expected probability of an IRS audit rises from 30.51 percent (the 25th percentile in our data) to 45.86 percent (the 75th percentile). In evidence supporting our second prediction, we find that the link between IRS oversight and equity pricing is stronger in firms with relatively poor corporate governance that experience worse agency problems. Consistent with recent theory on the corporate governance role that tax enforcement plays, our research suggests that a spillover benefit accompanying strict IRS monitoring is lower information asymmetry evident in equity financing costs.