Theft and Taxes

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Theft and Taxes

• Mihir Desai
• Harvard University and NBER
• Alexander Dyck
• University of Toronto
• Luigi Zingales
• University of Chicago, NBER and CEPR

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Motivation

• The state, thanks to its tax claim on cash flows,
  is de facto the largest minority shareholder in
  almost all corporations.
• Yet, its actions are not part of the standard
  analysis of corporate governance, nor does
  corporate governance enter the standard analysis
  of corporate taxation.
• In this paper we attempt to integrate the two and
  explore the implications.

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Three sets of implications

• 1. Corporate governance implications
• The characteristics of the corporate taxation
  system affect the protection of minority
  investors and the value of control.
• 2. Tax implications
• Characteristics of governance affect the tax
  system.
• We derive a hump-shaped relationship between tax
  rates and tax revenues and show that the shape of
  this curve depends on the quality of corporate
  governance.
• 3. A Rationale for the Corporate Tax
• We provide an alternative rationale for a
  corporate income tax as a certification tax.

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Outline

• 1.  Introduce model and derive corporate
  governance and tax implications
• 2.  Explore CGVT as justification for corporate
  tax
• 3. Test the governance implications
• 4. Test the tax implications  

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We start with a standard model of diversion

• Insider owns ? outside shareholders (1-?)
• Insider can divert a proportion d.
• She faces personal cost of stealing with cost
  increasing with quality of corporate governance
  (?).
• In a world without taxes,

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Add to this model a corporate income tax,
(modeled in an analagous way)

• Characterize tax system, by rate and enforcement
• It increases the benefits of diversion,
• It increases the cost of diverting money,
  (additional monitoring provided by the IRS)

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(Model implication 1) the impact of the tax
system on governance outcomes

• Ceteris paribus, countries with a higher tax rate
  will have higher levels of diversion. This
  effect is stronger where tax enforcement is
  weaker.
• Corollary 2
• For a given monitoring ability of the tax
  authorities (alpha), the introduction of a
  corporate tax is more likely to reduce diversion
  (and improve corporate governance) when
• The corporate governance system is weaker (lower
  gamma)
• Ownership is less concentrated (lower lamda)
• The tax rate is lower.

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• Result 2 The market value of a company decreases
  with the tax rate and increases with tax
  enforcement.
• Direct and indirect effect of tax rate
• Corollary
• Following an increase in enforcement, companies
  that were diverting proportionally more before
  will experience a larger increase in price.
• Corollary
• The value of control decreases with tax
  enforcement.

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(Model implication 2) the impact of governance on
the tax system

• Result 3 If , then corporate
  tax revenues as a function of corporate tax rates
  are hump-shaped.
• Corollary
• The sensitivity of tax revenues to tax rate
  changes increases with the quality of the
  corporate governance system.

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Robustness and limitations of the model

• Outsiders have no power in the model
• if they do, it can be subsumed in gamma.
• The state impacts the interaction between
  corporate insiders and outsiders only through
  taxes
• Other interventions (e.g. nationalization) can
  also be thought of as taxation
• Our model does not consider the full contracting
  space - what about side deals?
• deals between inside and outside shareholders -
  free rider problems
• More serious concerns about insider deals with
  State. But
• Nothing guarantees that after paying its bribe a
  company is not subject to additional requests for
  bribes
• The State faces an agency problem in its
  collection of taxes - . difficult to limit the
  skimming of the proceeds done by its delegated
  agents.
• Alternative enforcement functions
• Main results go through with other formulations

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2) A rationale for corporate tax?

• Can the impact that corporate taxes have on
  corporate governance justify the very existence
  of a separate tax on corporate income?
• Four arguments
• A - From historical record
• B Some circumstances when tax enforcers have a
  comparative advantage
• C Model results
• D Features of tax implementation

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A Historical record

• Another merit of this tax the federal corporate
  excise tax is the federal supervision which must
  be exercised in order to make the law effective
  over the annual accounts and business
  transactions of all corporations. . To me the
  publicity feature of the law is the only thing
  which makes the law of any special value for it
  is not going to be a great revenue producer.
• William H. Taft, June 16, 1909
• tax generated a need for a standard definition of
  income and other accounting variables, prompting
  the development of uniform accounting standards

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B Circumstances when tax enforcers have a
comparative advantage

• Economies of scope.
• Revenue influences enforcement
• Eat what you kill
• Two monitors better than one.
• Revealed preference Erickson, Hanlon, and Maydew
  (2003) show that managers were willing to pay
  taxes on false earnings in order to ensure that
  the IRS did not detect their fraudulent
  activities.

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C - Model

• No revenue objective
• Endogenize enforcement - tax enforcers need
  revenue to take action and extent of enforcement
  increases with revenue from enforcement is
• Under reasonable conditions there exists an
  optimal tax rate that minimizes diversion that is
  greater than zero
• The optimal tax rate increases with corporate
  governance
• E.g. - Cost of diversion40 cts on dollar,
  ownership cone55, tax parameter of .5-gt optimal
  tax17

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D - Other features of tax system - CGVT
perspective

• making interest expenses deductible,
• income paid in interest is certified by the fact
  it is paid out in cash to a third party.
• why legal entities such as the limited liability
  corporation and the subchapter S corporation are
  not subject to double taxation
• less prone to managerial agency problems
• corporate taxes are based on income rather than
  cash flow, sales, assets or other bases
• If an important reason for the corporate tax is
  its ability to certify the value of minority
  shareholders claims, it makes sense to use the
  value of their claim, i.e. profits, as a base

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3) Tests of corp. gov. implications

• Both tax avoidance and managerial diversion are
  difficult to document indeed, great efforts are
  taken to hide both.
• Focus on Russia
• Both these phenomena macroscopic and highly
  visible
• Dramatic change in enforcement with no change in
  rates
• i) Case study.
• ii) Across industry study
• iii) Within industry study

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Subtler tests

• Did voting premia change disproportionately in
  industries that faced the largest crackdown (oil
  and gas)?
• Within the oil and gas industry, did larger tax
  avoiders have higher excess returns around major
  enforcement dates?

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ii) Voting premia decline more in industries
targeted by enforcement actions
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iii) Within the oil industry, targeted tax
avoiders see greatest gains
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(4) Testing the tax predictions

• Capitalize on within-country variation
• Regress log of tax revenues on
• a) the tax rate (significant within-country
  variation),
• b) an interaction of the tax rate with
  governance variables
• c) control variables including country fixed
  effects.
•  

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Data sources

• Tax data
• Marginal corporate tax rates and revenues
  IMF/OTPR, 1979- 1997
• Characteristics of a representative firm
• Governance environment Private benefits of
  control (Dyck and Zingales (2003)) we have for 31
  countries)
• Ownership concentration Combined stakes of the
  top 3 shareholders (LLSV (1998), we have for 35
  countries)
• Data for controls
• Nominal GDP, Total tax revenues IMF
• Major oil exporter Member (or associate member
  of OPEC) or top 10 oil exporter. Exclude these
  countries from analysis.

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Conclusions

• 1. Corporate governance predictions
• The characteristics of the corporate taxation
  system affect the protection of minority
  investors and the value of control
• Evidence from Russia consistent with this.
• 2. Tax predictions
• Slope of Laffer curve depends on corporate
  governance
• International evidence consistent with this.
• 3. A Rationale for the Corporate Tax
• Corporate income tax justified as a
  certification tax

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Implications

• Any fiscal reform should consider corporate
  governance conditions
• Any corporate governance reform should consider
  fiscal conditions
• In the U.S. additional argument in favor of
  book-tax conformity and publicity of corporate
  tax records