We recently presented a new research paper at the 5th International Conference on the Shadow Economy which was also partly organized by GRAPE. Our paper develops a new theory on the interaction of corporate governance with the tax system. Our work was well received and we especially thank our discussant Aleksandar Vasilev for his insightful comments and multiple discussions.

The idea of our paper is simple: the asymmetric information problems that plague the relationship between management and owners, also show up between management and tax authorities. Between a manager and an owner, moral hazard arises when the manager fails to exert effort (obtaining a private benefit) after obtaining financing, consequently lowering the success of an entrepreneurial project. The standard solution to this problem is a contract that ensures the manager has an incentive to exert effort. We take this framework to a setting where the project is the production of new capital and show that tax rates and the tax system then affects the rate investment. This is all pretty strait forward.

Our key innovation is the introduction of the possibility of evasion of part of tax due through cost inflation by the manager. We model this scenario in a simultaneous move game between the manager and an auditor from the tax authority. Our results show that the presence of auditing and tax evasion lowers the manager's private benefit and hence her compensation for successful projects. This increases investment and has effects at the macro economy. The key to our result is the occasional auditing of the managers report of project outcomes for tax purposes. When the tax authority performs an audit, then the managers effort (technology choice in our case) is revealed. The audit is costly, and in a standard model of corporate governance would have to be borne by a large shareholder. The tax authority, due its claim on a share of the profits, acts as a typical large shareholder providing monitoring services. Our main finding is that in economic environments characterized by poor corporate governance, firms (or their managers) are likely to engage in tax evasion activities.

As we push forward this idea, we hope to be able to show that changes leverage ratios that show up in multiple macroeconomic models of the business cycle need not be viewed as exogenous shocks but rather as related to the system of corporate governance (including financial regulations) and the tax system (tax rates and frequency of auditing).