The Relationship Between the Management of Book Income and Taxable Income Under a Moderate Level of Book-Tax Conformity

We find evidence suggesting that taxable income management is not related to book income management in firms operating under a moderate level of book-tax conformity. For a sample of Israeli firms that the tax authorities determined had understated their earnings to avoid taxes, we do not find evidence of an overstatement of book earnings. Notably, public firms do not differ from private firms in this regard. Using a control sample of firms that were not subject to tax audits, we validate that self-selection does not affect our inferences. Given Israel's unique "intermediate'' level of book-tax conformity, an important practical contribution of the findings is in shedding more light on the question of the need for a substantial transition from nonconformity to full alignment in countries with large book-tax gaps (such as the United States). Our results showing that tax-avoiding firms in Israel, public and private alike, avoid book income management even if areas of book-tax nonconformity allow them to do so imply that a reduction in the divergence between the tax and the accounting rules may suffice to reduce managers' opportunistic (reporting) behavior.