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Using a large sample of public and private Italian companies, I investigate whether regional tax compliance affects earnings management activity in response to a decrease in the corporate tax rate. I find evidence that the higher the regional tax compliance where the company is based, the less managers engage in tax motivated earnings management. On the other hand, empirical results do not support the hypothesis that companies with an audit committee manage their earnings less in order to reduce their tax burden. Further analyses, however, show that the presence of an audit committee is relevant when interacted with the regional tax compliance. The impact of regional tax compliance on tax motivated earnings management declines when a company has an audit committee and this suggests a substitution effect between internal and external monitoring mechanisms. Finally, sensitivity tests show that both the intensity of earnings management for tax purposes and the effect of regional tax compliance are more material for small firms.

Regional tax compliance and tax motivated earnings management: evidence from the 2008 Italian tax reform