Corruption and Firm Tax Evasion

Although corruption and tax evasion are distinct and separate problems, they can easily become intertwined and reinforcing. A society that is more corrupt may enable more tax evasion as corrupt officials seek more income via bribes; conversely, higher levels of tax evasion may drive corruption by offering more opportunities for bribes. While a large body of work on each subject separately has emerged, the relationship between the two problems has remained a largely unexplored area. In particular, there is no theoretical work that examines the relationship between corruption and firm tax evasion, focusing on how the potential for bribery of tax officials affects a firm’s tax evasion decisions, and there is no empirical work that examines these linkages. This paper develops a theoretical model that incorporates the potential for bribery in a firm’s tax reporting decisions, and then tests the main results of the theory using firm level information on reporting obtained from the World Enterprise Survey and the Business Environment and Enterprise Performance Survey. Estimation methods include both instrumental variable methods and propensity score matching methods, and also control for potential endogeneity of evasion and corruption. Results demonstrate that it is corruption that largely drives higher levels of evasion; that is, corruption of tax officials is a statistically and economically significant determinant of tax evasion. Tax inspectors who request bribes result in reduction of sales reported for taxes of between 4 and 10 percentage points. Additionally, larger bribes result in higher levels of evasion, at least up to some point. These results indicate that governments seeking to increase their tax revenues must work first to ensure an honest tax administration.