Corporate tax evasion with agency costs

Abstract

This paper examines corporate tax evasion in the context of the contractual relationship between the shareholders of a firm and a tax manager who possesses private information regarding the extent of legally permissible reductions in taxable income, and who may also undertake illegal tax evasion. Using a costly state falsification framework, we characterize formally the optimal incentive compensation contract for the tax manager and, in particular, how the form of that contract changes in response to alternative enforcement policies imposed by the taxing authority. The optimal contract may adjust to offset, at least partially, the effect of sanctions against illegal evasion, and we find a new and policy-relevant non-equivalence result: penalties imposed on the tax manager are more effective in reducing evasion than are those imposed on shareholders.

Corporate governance, incentives, and tax avoidance

“…1 For example, Dyreng et al (2010) report evidence that executives who were previously employed by firms that are characterized as tax aggressive seem to import this aggressiveness to their new employer. Slemrod (2004), Crocker and Slemrod (2005), and Chen and Chu (2005) suggest that corporate tax noncompliance (i.e., extreme tax avoidance) could result from the tax reporting incentives provided by managers' incentivecompensation contracts. Consistent with this notion, there is empirical evidence that tax avoidance is associated with greater levels of incentive compensation (e.g., Phillips, 2003;Rego and Wilson, 2012).…”

Corporate deductibility provisions and managerial incentives

“…Besides corporate taxes, Desai et al also consider tax enforcement policies. See also Desai and Dharmapala (2006) and Crocker and Slemrod (2005) on tax enforcement policies when managers and shareholders have misaligned interests.…”

“…Note, with retained earnings as the marginal source of funds the investment responses that are crucial to Proposition 2 and 3 are not altered and hence Proposition 2 and 3 equally apply in the presence of dividend taxation, c.f. (11). However, the investment responses do not always extend to situations in which firms rely on new share issues to finance investments.…”

“…When investments are financed via retained earnings, the government participates in the costs and benefits of investing productively at rate τ d , but participates only in the costs of investing unproductively, c.f. (11).…”

“…Hence, the dividend tax and the incentive contract are equivalent in their effects on investments, c.f. (11). Since the sharing parameter is optimized, changes in the dividend tax rate do not influence private welfare.…”