Internalcontrolversusexternal manipulationamodelofcorporate.pdfVIP

mss # Chen and Chu; art. # 09; RAND Journal of Economics vol. 36(1) RAND Journal of Economics Vol. 36, No. 1, Spring 2005 pp. 151–164 Internal control versus external manipulation: a model of corporate income tax evasion Kong-Pin Chen∗ and C.Y. Cyrus Chu∗∗ We offer a formal model of corporate income tax evasion. While individual tax evasion is essentially a portfolio-selection problem, corporate income tax evasion is much more complicated. When the owner of a firm decides to evade taxes, not only does she risk being detected by the tax authorities, more importantly, the optimal compensation scheme offered to the employees will also be altered. Specifically, due to the illegal nature of tax evasion, the contract offered to the manager is necessarily incomplete. This creates a distortion in the manager’s effort and reduces the efficiency of the contract. Tax evasion thus increases the profit retained by the firm not only at the risk of being detected, but also at the cost of efficiency loss in internal control. 1. Introduction The classic article of Allingham and Sandmo (1972) resulted in much theoretical and em- pirical analysis on why and to what extent an individual would evade taxes.1 However, corporate income tax evasion has to date attracted relatively scant theoretical investigation.2 One reason for such an unbalanced development in the research of tax evasion is that essentially no corporate income compliance microdata have been previously available to researchers. Another and per- haps more important reason is that the conceptual difference in the evasion decision between an individual and a corporation is hard to capture analytically. The stan