The Effect of Book-Tax Differences on Audit Selection of National Tax Administration

This study uses 2000 and 2001 Taiwan's business income tax returns data to examine the effect of firms' book-tax differences on the audit probabilities of tax authority, and to investigate the relationship between firms' book-tax differences and the magnitude of the detected underreported tax liabilities. The empirical results reveal that the more book income exceeds taxable income, the more evidence that the tax authority may have against the firms with aggressive tax reporting. Therefore, this study finds that the audit probabilities of tax authority increase as book-tax differences of firms increase. And conditional on being selected for audit, firms with larger book-tax differences are more likely to have detected understatements of tax liability. This study provides evidences that firms cannot costlessly maximize financial reporting benefits and tax savings independently. Therefore, the results of this study may be used to warn firms from engaging in aggressive financial and tax reporting.