Do Japanese Firms Manage Earnings in Response to Tax Rate Reductions in the Late 1990s?

Abstract

This study investigates whether Japanese firms manage their book income in response to changes in the statutory rate of corporate income taxes. Prior studies examine book income or current accruals as the proxy for taxable income shifting. However, in the U.S., there are few direct links between taxable income and book income, which in turn might introduce significant errors into earnings management measures. Although we also focus on accounting accruals, the link between the two incomes in Japan is much more explicit, which enables us to examine taxable income shifting more directly. We find that there are significantly negative discretionary accruals for the years immediately preceding a tax rate reduction. These results show that Japanese firms manage their book income to minimize tax costs. This suggests that conforming the two incomes does not necessarily eliminate tax-induced earnings management, and therefore has very important implications for the recent debate over book-tax conformity.