The Internal Revenue Service (IRS) routinely monitors public companies to assess compliance with tax laws. The frequency of this monitoring is expected to increase significantly since the IRS recently announced its updated Strategic Operating Plan associated with the Inflation Reduction Act. In response to IRS monitoring, companies may incur costs that result from complying with the monitoring efforts and paying any additional taxes, penalties, or fees due.

Despite these costs, research suggests that companies’ shareholders and other stakeholders may derive net benefits from IRS monitoring. This is because it can encourage companies to improve their internal information so they have accurate, timely information when seeking to comply. Additionally, the IRS can serve as an external monitor over management, thereby mitigating actions that personally benefit management at the expense of shareholders. These developments can improve financial reporting quality and lower the cost of capital (Guedhami and Pittman 2008; El Ghoul et al. 2011; Hanlon et al. 2014).

Impact of IRS Monitoring on Firms’ Employees and Customers

Although the effects of IRS monitoring on traditional stakeholders have been widely investigated, its effects on non-traditional stakeholders are largely unexplored. In a new paper, we aim to fill IRS monitoring of specific companies and those companies’ proclivity to commit non-financial corporate misconduct.

While traditional corporate misconduct, such as the misuse of corporate finances or fraud, directly affects traditional stakeholders such as corporate insiders or equity shareholders, non-financial corporate misconduct, which includes employee-safety, consumer-protection, and environmental-related offenses, primarily affects non-traditional stakeholders, such as employees, customers, or community members.

In our paper, we capture the occurrence, frequency, and severity of non-financial corporate misconduct using the Violation Tracker database compiled by GoodJobsFirst.Org. This database compiles over 600,000 incidents of corporate misconduct, and their associated penalties, that have been issued by over 450 state and federal regulatory agencies since 2000, with total penalties amounting to more than $1 trillion.

Within the Violation Tracker database, we can observe which company committed the misconduct, when the incident was punished, the type of misconduct (employment-related, environmental-related, etc.), the penalties imposed, and which regulatory agencies were involved in reviewing and penalizing the corporation. For example, in 2013 Aramark settled litigation with the federal U.S. District Court for the Northern District of California related to claims that it underpaid employees. In the Violation Tracker database, we observe that Aramark settled with a federal agency for $2.75 million in 2013 due to “employment-related offenses”.

To conduct our investigation, we also require a measure that captures the level of IRS monitoring a particular company is subject to. The measure we use is company-specific, varies year-over-year, and is derived from public companies’ mandatory disclosures (Armstrong et al. 2024).

Key Findings

We find that the propensity, frequency, and severity (based on penalty amounts) of regulatory violations are all increasing in response to IRS monitoring. For example, a one standard deviation increase in our measure of IRS monitoring is associated with a 6.67 percent increase in the likelihood of a company being punished for non-financial corporate misconduct.

We propose at least two reasons, or mechanisms, for this result. First, as companies incur costs or anticipate future costs associated with IRS monitoring, they may reduce costs elsewhere, which could intentionally or unintentionally lead to an increase in non-financial misconduct. For example, companies may choose to forego or delay updating safety procedures or equipment due to the expected, yet also uncertain costs associated with IRS monitoring. This can occur either because of direct policy changes implemented by executives or simply because executives impose new budgetary measures on lower-level managers, and these lower-level managers respond to the cost-cutting mandates by taking actions that lead to non-financial misconduct. Second, IRS monitoring efforts impose additional administrative and regulatory burdens on companies (i.e., compliance costs). These additional burdens may cause companies with tight budgets to overlook or be distracted from other important issues, leading to an increase in misconduct.

Our analyses suggest that the positive relation between IRS monitoring and non-financial corporate misconduct is largely driven by the first mechanism. For example, we find that our results are driven by companies that are financially constrained and those with better internal information environments, which help facilitate the implementation of strategic actions, such as cost-cutting initiatives.

Conclusion

Overall, our results indicate that IRS monitoring is associated with an increased incidence, frequency, and severity of non-financial corporate misconduct, suggesting increased IRS monitoring may indirectly harm non-traditional stakeholders. With the IRS expected to triple its audit rate on large corporations in 2024, we believe it is important for policymakers to consider these findings.

REFERENCES

Armstrong, D. M., S. Glaeser, and J. L. Hoopes. 2024. Measuring firm exposure to government agencies. Journal of Accounting and Economics:101703.

El Ghoul, S., O. Guedhami, and J. Pittman. 2011. The role of IRS monitoring in equity pricing in public firms. Contemporary Accounting Research 28 (2):643-674.

Guedhami, O., and J. Pittman. 2008. The importance of IRS monitoring to debt pricing in private firms. Journal of Financial Economics 90 (1):38-58.

Hanlon, M., J. L. Hoopes, and N. Shroff. 2014. The effect of tax authority monitoring and enforcement on financial reporting quality. The Journal of the American Taxation Association 36 (2):137-170.

This post comes to us from professors Duke Ferguson at the University of Kentucky’s Gatton College of Business and Economics, Robert Hills at Pennsylvania State University’s Smeal College of Business, and Trent Krupa at the University of Arkansas’ Walton College of Business. It is based on their recent paper. “IRS Monitoring and Corporate Non-Financial Misconduct,” available here.