DP4816 | Theft and Taxes

Publication Date

23/12/2004

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Abstract

This Paper analyses the interaction between corporate taxes and corporate governance. We show that the characteristics of a taxation system affect the extraction of private benefits by company insiders. A higher tax rate increases the amount of income insiders divert and thus worsens governance outcomes. In contrast, stronger tax enforcement reduces diversion and, in so doing, can raise the stock market value of a company in spite of the increase in the tax burden. We also show that the corporate governance system affects the level of tax revenues and the sensitivity of tax revenues to tax changes. When the corporate governance system is ineffective (i.e., when it is easy to divert income), an increase in the tax rate can reduce tax revenues. We test this prediction in a panel of countries. Consistent with the model, we find that corporate tax rate increases have smaller (in fact, negative) effects on revenues when corporate governance is weaker. Finally, this approach provides a novel justification for the existence of a separate corporate tax based on profits.