Corporate Governance and Taxation

This paper analyzes the interaction between corporate taxes and corporate governance. We show that the characteristics of a taxation system impact the size of private benefits managers are able to extract. A higher tax rate increases the amount of income a manager would divert, while stronger tax enforcement reduces it 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 and sensitivity of tax revenues to tax changes. When the corporate governance system is ineffective (i.e., when it is easy to divert income) or when ownership concentration levels are high, an increase in the tax rate can reduce tax revenues generating a corporate version of the Laffer-curve. We test the Laffer-curve predictions 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 ownership is more concentrated and corporate governance is worse. * We thank Mehmet Beceren, Kent McNellie, Bill Simpson, and James Zeitler for their valuable research assistance. We also thank René Stulz and participants at seminars at the University of Chicago, the University of North Carolina at Chapel Hill, the University of Michigan, the Kennedy School of Government, the NBER University Research Conference, the NBER PF Summer Institute, Vanderbilt University, and Moscow’s NES for their comments. Desai and Dyck thank the Division of Research at Harvard Business School and Zingales the Center for Research on Security Prices and the George Stigler Center at the University of Chicago for financial support. The state, thanks to its tax claim on cash flows, is de facto the largest minority shareholder in almost all corporations. Yet, the state’s actions are not part of the standard analysis of corporate governance, which has typically emphasized legal investors’ protections (as in La Porta et al (1998) and Shleifer and Wolfenzon (2002)), the role of boards (e.g., Hermalin and Weisbach (1998)), and the presence of large investors (Morck, Shleifer and Vishny (1988). This absence is even more remarkable, given the extensive literature analyzing the impact of taxes on corporate financing decisions and corporate investment decisions (see Auerbach 2002). Similarly, analyses of tax avoidance and evasion typically focus on the individual tax system (see Slemrod and Yitzhaki 2002). And even when they do focus on corporate taxation, they typically ignore the effect that weaknesses in corporate governance have on corporate responses to changes in the corporate tax rate. In this paper, we provide a simple reason why the analysis of these two topics should be integrated. Any transaction designed with the sole purpose of avoiding taxes is illegal. Hence, corporate tax optimization implies some lying in public documents (at the very least on the primary purpose of certain transactions). This lying inevitably makes a company’s affairs and accounts more opaque to outside investors. And this opacity will have a negative impact on the ability of investors to control insiders. Hence, tax systems that induce more sheltering will worsen corporate governance. The converse is also true. Better corporate governance implies more transparency and this transparency makes it more difficult to shelter income. Hence, better corporate governance reduces tax sheltering. We start by assuming the existence of a standard corporate tax system and we study the effects this system has on the amount of income diverted by insiders. Our key assumption is that tax sheltering, which we define as any decision that if noted by the tax authority would be challenged, makes corporate accounts more opaque and, consequently, makes it easier to divert corporate resources. We validate this assumption by looking at an environment (Russia) where both tax avoidance and managerial diversion are more macroscopic. Based on this assumption, we build a simple model of optimal income sheltering, where the decision maker is an insider (a controlling shareholder or a manager). Besides the obvious