The Effect of Audit Effort on the Association between ESG and Tax Avoidance
Asian Tax Journal Vol. 25 No. 2 (2024), pp. 9-51
Abstract
The purpose of this study is to investigate the relationship between environmental, social, and governance (ESG) and corporate tax avoidance, and the moderating effect of audit effort on that relationship. Therefore, we test whether firms with high ESG ratings are associated with greater or lesser tax avoidance. We also investigate whether the role of auditor’s audit effort affects the relationship between ESG and tax avoidance. For our empirical tests, we use a sample of firms with positive pretax income and data from 2018 through 2022 to construct four tax avoidance measures ：the book－tax income difference (BTD), the discretionary BTD of Desai and Dharmapala (2006), the current cash effective tax rate (ETR), and the GAAP ETR. We use the annual ESG ratings announced by the Korea Corporate Governance Service (KCGS). To study the effect of ESG on tax avoidance and the moderating effect of audit effort in this relationship, we uses four audit effort proxies：the actual－standard differences in audit hours, the increase in audit hours, the increase in audit fees, and the increase in audit fees per hours. We use our hand－collected dataset for the actual－standard differences in audit hours to overcome this limitation in prior research. The resulting sample in our study is 2,379 firm－year observations for the period 2018 to 2022. By using Korean listed firms from 2018 to 2022, we first find that ESG is positively associated with tax avoidance. This results suggest that firms with higher ESG scores avoid paying more taxes. Second, we also find that the increases of auditor’s audit effort attenuates the positive the relationship between ESG and tax avoidance. Our finding show that audit effort tends to dampen this positive relationship between ESG and firms’ tax avoidance. Because auditors who audit clients who are tax aggressive face higher engagement risk. Hence, auditors have incentives to influence clients’ aggressive tax activities. Given previous study’s rather mixed findings regarding the relation between ESG and tax avoidance (e.g., Jung and Yu 2021；Yoon et al. 2021；Kim et al. 2022；Park and Lee 2022), we add to the literature by investigating how audit effort affects it. We provide novel evidence that the role of audit effort significantly moderate the assocation between ESG and tax avoidance. As far as we know, this is the first study that uses audit effort to explain the relationship between ESG and corporate tax avoidance. Furthermore, the contribution of our study is empirically present that the overall effect of the introduction of the Standard Audit Hours Policy (SAHP) was effective in improving the audit effort providing implications for supervisory authorities and policymakers.
Keywords
- tax avoidance
- ESG
- audit effort
- actual－standard differences in audit hours
- increase in audit fees per hours
- moderating effect
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