In choosing transparency, firms must trade off the benefits from better access to finance against the cost of a greater tax burden. We study this trade-off in a model with distortionary taxes and endogenous rationing of external finance. The evidence from two different data sets, one formed only by listed firms and another mainly by unlisted firms, bears out the model’s predictions: First, investment and access to finance are positively correlated with accounting transparency, especially in firms that depend more on external finance, and are negatively correlated with tax pressure. Second, transparency is negatively correlated with tax pressure, particularly in sectors where firms are less dependent on external finance, and is positively correlated with tax enforcement. Finally, financial development enhances the positive effect of transparency on investment, and encourages transparency by financially dependent firms.
Financial Markets Group Discussion Papers DP 705