Does Tax Risk Attenuate the Positive Association between Internal and External Information Quality?

Abstract

This study examines whether tax risk attenuates the positive association between firms' internal information quality (IIQ) and external information quality (EIQ). Theoretically, higher IIQ allows managers to increase the quality of disclosures to external market participants, which improves EIQ. However, engaging in risky tax planning strategies discourages managers from disclosing information due to the risk of drawing attention from tax authorities (i.e., proprietary costs). I hypothesize and find that the association between IIQ and EIQ is fully attenuated for firms in the highest quintile of tax risk. A structural equation model and supplemental tests that account for business-related proprietary costs and uncertainty corroborate my findings. Overall, my results imply that firms with higher IIQ improve EIQ, on average. However, higher tax risk breaks down this link due to the proprietary costs of disclosing tax strategies to tax authorities.