Corporate Governance, Taxation and Business Cycles

We present an agency model of corporate tax auditing by a residual claimant government and embed it into a macro model with financial constraints. In our economy, entrepreneurs with access to risky investment technologies raise funds by issuing equity claims to new capital. Information asymmetries create incentives to choose a riskier but cheaper technology that provides private benefits and opportunities to evade taxes. Random auditing by the government for tax verification reveals technology choice, reducing the asymmetric information problem between lenders and borrowers. We show that moderate corporate governance quality accompanied by high taxes raise output, investment and consumption.

Non-technical summary: Unintended consequences of Mr Taxman