Tax evasion and financial development under asymmetric information in credit markets

Recent empirical studies have documented that after controlling for variables related to state capacity, the incidence of firms' tax evasion on their sales is negatively correlated with the level of a country's financial development. Motivated by this stylized fact, our paper takes state capacity as given and provides an alternative theory that is built upon asymmetric information in credit markets, particularly within developing economies. We analytically show that with a more developed financial sector that exhibits smaller agency costs, the government of a rich small-open-economy country will raise its optimal tax-auditing probability, which in turn leads to more tax compliance. Our baseline model also yields an empirically-realistic positive correlation between financial development and the ratio of tax revenue over GDP. In an extended setting which allows for size-dependent probabilities of tax detection, we find that consistent with the empirical evidence, large firms comply with taxes whereas small firms evade taxes.