Taxability and Government Support of Business Activity: Testing Theories of Social-Contract Failure

Much theory of the state assumes a contractual relationship between state and society, where the former provides services valued by the latter, typically in return for revenues. However, as emphasized by many scholars, various transaction costs endemic to state-society relations may prevent the negotiation of an efficient Coasian contract. This paper examines this proposition by exploring the nature of government support for business activity in postcommunist Europe and Asia, where many of the transaction costs that hinder efficient contracting between state and society — the state’s inability to commit, information asymmetries between state and society, and collective-action problems within society — are especially acute. Analysis of data from a sample of firms in 23 postcommunist countries demonstrates that the state provides more support along a variety of dimensions to firms which are more taxable, i.e. firms from which the state can extract a greater share of revenues. Further, firms which report less of their revenues to tax authorities are more likely to say they would pay more taxes to increase government support. Thus, state and society appear to be trapped by their failure to efficiently contract, with firms hiding as much of their revenues as they think they can get away with, knowing that the state will respond by undersupporting business activity.