Unintended benefits of Mr Taxman

Unintended benefits of Mr Taxman

The government, due to its tax claim on profits, is also the de facto majority shareholder of most corporations. While the government does not enjoy any voting rights, its occasional auditing of firms to verify profit declarations for tax purposes may help outside investors infer the private benefits extracted by controlling shareholders.

The level of private benefits that can be extracted by corporate insiders defines corporate governance quality. Empirical evidence suggests that raising funds from outside investors is easier and cheaper in jurisdictions with high corporate governance quality or low levels of private benefits. In the United States, firms facing a high probability of audit from tax authorities enjoy a lower cost of funds, up to 25 basis points lower interest on credit. Furthermore, firms that have to make income restatements following tax audits subsequently face an interest penalty equivalent to 85 basis points over the LIBOR.

We formalize these empirical findings in an equilibrium model where new capital production is subject to moral hazard; controlling shareholders have an incentive to extract private benefits once funds have been secured from outsiders. Extraction of benefits however increases risk: the chance of success for an investment project is lower if managers are enjoying private benefits. We show that high taxes, by reducing the amount of funds that can be credibly pledged to outside investors, increase aggregate consumption output and investment. This is due to the reduction in the mortgageable fraction of new capital or equity. When taxes are high and controlling shareholders can pledge a smaller fraction of the outcome of investment, they have a lower incentive to engage in risky behavior. The same outcome is observed when the quality of corporate governance is low: again the mortgageable fraction of equity is lower and risk taking is suppressed. Low taxes and high corporate governance quality have the opposite effect.

When a liquidity or productivity shock occurs, corporate insiders or controlling shareholders experience a negative net worth shock. Since net worth determines how much can be raised from outsiders, and consequently aggregate investment, a net worth shock in a low tax environment results into a steeper fall in capital (which needs to be replenished due to depreciation), and output. The same occurs with high corporate governance quality. In summary, aggregate investment, output and consumption are maximized under high taxes and moderate quality governance institutions.