Transparency, Information Shocks, and Tax Avoidance

Abstract

This study helps provide clarity to the prior mixed findings on the association between the transparency of the financial information environment and tax avoidance by studying the effect that transparency has on tax avoidance in a cross-country sample through aggregate - and firm-level tests. By using the adoption of IFRS and the initial enforcement of insider trading laws around the world as exogenous shocks to transparency, this study addresses empirical concerns regarding endogeneity and reverse causality not fully addressed in prior research. Results using firm- and country-level (aggregate) measures of transparency and tax avoidance show that countries and firms with greater levels of transparency exhibit lower levels of tax avoidance and that the effect of country-level transparency is incremental to firm-level transparency. Results of difference-in-difference tests using the adoption of IFRS as an exogenous shock to financial transparency (while also controlling for other, potentially confounding changes around IFRS adoption) provide further evidence that transparency has a statistically and economically significant effect on tax avoidance. Additional tests using the initial enforcement of insider trading laws as another exogenous shock as well as tests that address potential correlated but omitted variables show consistent results. These findings suggest that financial transparency is an important tool which regulators can use in battling tax avoidance and that laws passed around the time of IFRS adoption to ensure that firms did not have an increase in tax liability may have been less than effective due to the corresponding effect of IFRS adoption on transparency.