Tax Evasion and Financial Development under Asymmetric Information in Credit Markets

Abstract

Recent empirical studies have documented that the incidence of firms` tax evasion on their sales is negatively correlated with the country`s level of financial development. Our analysis shows that this stylized fact can be theoretically accounted for within a small-open-economy model of optimal tax enforcement under asymmetric information in credit markets. In an economy with a more developed financial sector that exhibits smaller agency costs, we find that the government will raise its optimal probability of tax auditing, which in turn leads to more tax compliance. It follows that financial development and tax evasion are inversely related, as observed in the actual data.