Earnings management as a consequence of income tax reforms

This study explores the behavior of Croatian manufacturing companies in the context of the income tax reforms that have been implemented twice in the last ten years (2016 and 2020). The research sample comprises 4,649 (2016 reform) and 4,651 (2020 reform) manufacturing companies. The analysis of the income distribution shows that the companies included in the sample avoid publishing small losses. The same analysis only partially (for the 2016 reform) confirmed downward earnings management to reduce income tax payments. However, the analysis of differences in discretionary accruals based on paired-sample t-tests and Wilcoxon signed-rank tests for both income tax reforms confirmed the expected tax-aggressive behavior of the sampled firms. Namely, firms used earnings management techniques for income shifting from years (2016 and 2020) with higher income tax rates to years (2017 and 2021) with lower income tax rates. The regression results mainly support the existing theory on the other motives of earnings management and confirm the importance of company indebtedness (only for the 2020 reform), financial statement audit, and company size. As a particular contribution of this study, we highlight the evidence that the application of two income tax rates (higher 18% and lower 12% - from 2017; 10% - from 2021) creates additional pressure on downward earnings management for those companies that have to apply a higher income tax rate.