This study employs a natural experiment to examine the tax effects of a change in the level of conformity between tax and financial reporting in China for firms with different financial reporting incentives. We find that in a full book-tax conformity system, firms with incentives to report higher book income pay significantly higher income tax (per dollar of sales) than do firms without the same incentives. Although we do not find similar evidence in a non-conformed system, we observe cross-sectional variation in taxes paid by firms of varying sizes: by exploiting non-conforming financial reporting rules to a greater extent, large firms pay proportionately lower taxes than do small firms. To improve financial reporting quality, many countries have adopted International Financial Reporting Standards (IFRS) that may affect book-tax reporting differences. Our results suggest that this policy alternative is less desirable from a tax perspective. Therefore, accounting standard setters and securities regulators around the world should consider not only how such a change is intended to benefit capital markets, but also what unintended consequences this policy choice might have for government revenue. Our results also strengthen the government policy position on giving more tax relief to small firms.

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