We develop an agency model of corporate tax evasion and auditing by a residual claimant government and embed it to a macroeconomic environment characterised by credit con- straints. We show that changes in the revenue system; tax and audit rates, can directly affect asset prices and inflate the effects of exogenous shocks to the economy.

1. Corporate Governance, Tax Evasion and Business
Cycles
Gilbert Mbara,
with
Joanna Tyrowicz & Ryszard Kokoszczynski
University of Warsaw
5th International Conference on “The Shadow Economy”,
Warsaw
July 28, 2017
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2. Motivation
Agency problem: managers vs owners/investors. - manager can
extract income or private benefit. Overcoming agency problem
requires monitoring (large shareholder).
Desai (2007, Theft and taxes, JFE): Government is largest minority
shareholder of all firms due to tax claim on profits =⇒ can provide
monitoring service “freely!”
Corporate governance quality and tax evasion generally tend to pull
in opposite directions: the presence of one crowds out the other.
Example from literature: Artwood (2012,The Accounting Review) –
firms tend to avoid taxes less when required book tax conformity is
higher. Book-tax conformity ≡ quality of corporate governance.
Idea: can the existence of monitoring for tax purposes reduce credit
constraints arising from agency problems?
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3. Road map
Motivation
Economic Environment
Agency Problem
Taxation
Tax Evasion
Calibration
Macroeconomic Equilibrium
Conclusions
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4. Macroeconomic Setting
Follows Kiyotaki and Moore (2012): Liquidity, Business Cycles, and
Monetary Policy
Economy populated by entrepreneurs, use capital Kt−1 to produce
output Yt = F(Kt−1), used for consumption Ct and investment It.
Capital depreciates every period at rate δ:
Kt = (1 − δ)Kt−1 + f(It), where f(It) = capital production technology.
Only a fraction π of entrepreneurs have an opportunity to produce
new capital. Label these as borrowers b
b s may issue equity claims to the future return of newly produced
capital.
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5. Capital Production
Two Assumptions:
Liquidity constraint: b can only sell a fraction φt < 1 of her current
equity holdings =⇒ needs to borrow (no self financing).
Credit constraint: b has access to two types of production
technologies: safe and risky =⇒ needs to finance part of investment
from own funds OR can only sell a fraction θt of equity claims to
newly produced capital.
Let ab
t−1 be b ’s equity holdings at beginning of date t: constraints
=⇒
ab
t = (1 − θt)it + (1 − φt)(1 − δ)ab
t−1
Our contribution: how corporate governance and tax evasion affect θt.
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6. Microeconomic Setting
Follows Holmstrom and Tirole (1997).
Investing Entrepreneurs (borrowers): b
Two types technologies for producing capital
Safe tech: uses it units of the consumption good to produce Rit units of
capital with probability pH or 0 with probability (1 − pH).
Risky tech: uses iL,t < it units of the consumption good to produce Rit
units of capital with probability pL < pH or 0 with probability (1 − pL).
The subscripts {H, L} denote high and low respectively.
Non-Investing Entrepreneurs (lenders): l
Make zero profit.
Enter contract with b s specifying how profit qtRit is shared:
Rb
goes to the borrower and Rl
goes to the lenders: Rb
+ Rl
= qtRit,
where qt ≡ price of capital.
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7. Agency Problem
b has private information about the technology she has used.
If b chooses:
Safey tech: Net Return = (qtR − 1)it
Risky tech: Net Return = (qtRit − iL,t)
= (qtR − 1)it + Bit ,
Private Benefit: Bit > 0, B ∈ (0, 1) is not freely observable.
b faces the following trade-off once financing is obtained:
choose risky tech to gain Bit but reduce success probability to pL < pH.
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8. Incentive Compatible Contract
Incentive compatible contract specifies:
pHRb
≥ pLRb
+ Bit or Rb
≥
Bit
p
(ICb)
Highest pledgeable income to l
≡ pH qtRit −
Bit
p
= pH(qtRit − Rb
)
Lender breakeven condition: the expected pledgeable income exceed
the borrowed amount:
pH qtRit − Rb
≥ it − At (IRl)
At = b ’s net worth. Necessary condition for financing to occur:
At ≥ ¯A = it − pH(qtRit − Rb
)
= 1 − pH qtR −
B
p
it = (1 − θt)it
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9. Taxation
Assume there is a government that can tax profits from investment:
A proportional tax τ is levied on final profit:
Profit after Tax = (1 − τ)(qtR − 1)it = Rb
+ Rl
The incentive compatibility constraint becomes:
pHRb
≥ pLRb
+ (1 − τ)Bit or Rb
≥
(1 − τ)Bit
p
(ICb)
The break-even condition for the lender to participate becomes:
pH (1 − τ)(qtR − 1)it − Rb
≥ it − At (IRl)
Credit Constraint is At ≥ (1 − θt)it and the maximum investment
satisfies it ≤ ¯mAt, where ¯m = 1
1−¯θt
:
¯θt = pH(1 − τ) [(qtR − 1) − B/ p]
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10. Tax Evasion
Possibility of evading tax by the entrepreneur together with audits or
monitoring.
Evasion means: l declares cost it when successful using the risky
tech instead of true cost iL,t i.e. hides the private benefit Bit.
An audit by tax authority can reveal actual tech used.
The monitor at cost ζ per audit:
discovers the undeclared private benefit B (evaded amount) with
probability y
discovers nothing with probability (1 − y)
If evasion is discovered, the entrepreneur faces a surcharge s in
addition to her tax liabilities.
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11. Evasion–Monitoring Game
In the presence of audits, the entrepreneur can either declare her true
income or report untruthfully.
Strategies:
Tax authority: audit (A) or no-audit (NA)
b : truthful (T) and not-truthful (NT).
Audit response cost: proportional to level of investment ηit for
0 < η < 1.
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12. Game Matrix
τBi − ζ τBi
pLRb
+ (1 − τ)Bi pLRb
+ (1 − τ)Bi
(τ + s)Bi − ζ −(τ + s)Bi
pLRb
+ 1 − (τ + s) Bi − ηi Bi
Audit
(A)
Not Audit
(NA)
Truth (T)
No Truth (NT)
Tax Authority
Firm
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13. Game Solution
No Nash Equilibrium in pure strategies – consider mixed strategies.
Let l declare her true income with probability x while auditing takes
place with probability y.
The expected payoff of the randomising strategy:
E(x) = x y pLRb
+ (1 − τ)Bi − ηi + (1 − y) pLRb
+ (1 − τ)Bi
+ (1 − x) y pLRb
+ 1 − (τ + s) Bi − ηi + (1 − y)Bi (1)
l : Chooses x such that
∂E(x)
∂y
= 0
This implies that the probability of declaring true income is given by:
x = 1 −
ηit
pLRb − (τ + s)Bit
(2)
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14. Incentive Compatibility with Evasion and Random
Audits
Let Ub
S and Ub
R be the borrowers return when choosing the safer and
riskier technologies respectively.
Safe tech: always reports truthfully =⇒ Ub
S = pHRb
Risky tech:
truthful with probability x
untruthful with probability (1 − x)
caught with probability y
Ub
R = x pLRb
+ (1 − τ)Bi
+ (1 − x) y pLRb
+ [1 − (τ + s)]Bi + (1 − y) pLRb
+ Bi
Incentive compatibility to choose safe tech: Ub
S ≥ Ub
R:
Rb
≥ 1 − y(τ + s) − x[τ − y(τ + s)] ×
Bi
p
≡ ω ×
Bi
p
(ICb)
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15. Lender’s Break Even
Credit Constraint is At ≥ (1 − ¯¯θt)it, investment satisfies i ≤ ¯¯mA:
¯¯m =
1
1 − ¯¯θ
and ¯¯θt = pH (1 − τ)(qtR − 1) − ω ×
B
p
ω = 1 − y(τ + s) − x[τ − y(τ + s)]
Without auditing, y = 0 and nobody reports truthfully, x = 0 which
gives ω = 1 and ¯¯m > ¯m.
Without tax evasion, x = 1 (truthful reporting) and ω = (1 − τ)
implies ¯¯m = ¯m.
An increase in evasion lowers ω and decreases investment.
∂ ¯¯m
∂y
=
pH
¯¯m
2 (τ + s)(1 − x)
B
p
> 0
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16. Calibrating x
Using Rb
= ω
Bit
p
with x = 1 −
ηit
pLRb − (τ + s)Bit
=⇒
Quadratic equation in x, solve for root < 1: x = 0.66374
Table: Calibration of model parameters
Parameter Description Value
B Private Benefit 0.15
η Audit Response Cost 0.01
pH Safe Tech Success Prob. 0.95
pL Risky Tech Success Prob. 0.45
τ Corporate Tax Rate 0.35
s Surcharge for evasion 1.5 × τ
y Audit Prob. 0.08
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17. Variation in Truthful Reporting
Figure: How changes in governance and taxation affect evasion
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18. Macro Timing of Events
1. Aggregate productivity is realized and production takes place.
2. π is revealed.
a. Investing agents choose consumption, sell a fraction φt of their
depreciated asset holdings.
b. Non-investing agents choose consumption and purchase assets from
investing agents.
3. Within period capital production occurs subject to agency problems.
4. pHRit units of new capital are added to the economy.
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19. Macroeconomic Equilibrium
b ’s budget constraint:
cb
t + (1 − θt)it = rt + (1 − δ)φtqt ab
t−1
l ’s budget constraint:
cl
t + qtal
t = [rt + qt(1 − δ)] al
t−1
Aggregates to:
Ct = Yt + π(φtqt + (1 − φt)qR
t ) + (1 − π)qt (1 − δ)Kt−1
− (πqR
t + (1 − π)qt)Kt
Kt = (1 − δ)Kt−1 + pHRIt where qR
t =
(1 − θt)qt p
pHωB
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20. Conclusions
Microfoundatons of changes in the credit constraints.
θt depends on quality of corporate governance B, and the tax system
y, τ, s which are related to evasion x.
Changes in the tax system affect both evasion and how much can be
borrowed → consequences for business cycles.
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