Corporate tax enforcement has become a critical issue for many governments in recent years, given the massive amount of lost revenues and budget deficits. There is empirical evidence that corporate tax avoidance has increased over the past decades.  Some countries have responded by increasing coordination to combat tax avoidance. For example, the OECD countries created the Base Erosion and Profit Shifting (BEPS) project. At the same time, the IRS has seen its budget reduced in recent years. 
While policymakers have considered multiple remedies for combating aggressive corporate tax avoidance, such as withholding rules and information sharing, the IMF notes that “auditing remains crucial.”  Consistent with this idea, to aid the implementations of BEPS in developing countries, the OECD and the United Nations Development Program jointly started the Tax Inspectors Without Borders initiative to encourage greater investments in tax return audit capacity and to improve actual audit results. 
The obvious outcome of greater tax enforcement is a reduction in aggressive corporate tax avoidance. However, it is less clear whether and how tax enforcement affects firms and their stakeholders beyond tax payments. Understanding these “tax enforcement spillovers” is critical in assessing the overall net benefit of tax enforcement.
Our study explores the impact of corporate tax enforcement on a key firm stakeholder: banks. Specifically, we explore whether corporate tax enforcement impacts the amount and quality of bank lending to firms. Given the important role banks play in providing capital to businesses—especially small and midsized firms—corporate tax enforcement could have important implications for economic growth.
How can tax enforcement impact bank lending? First, it can affect the usefulness of the tax return as a source of information about the potential borrower. Banks typically require tax returns when lending to small and midsized firms, either as a “check” against, or a replacement for, financial statements. Tax avoidance usually involves the manipulation of tax returns and financial statements. Greater tax enforcement reduces this manipulation, meaning that the tax return provides a clearer signal of the firm’s creditworthiness. Thus, the bank may be more willing to lend when tax enforcement is greater, since it has a more accurate understanding of the potential borrower’s future prospects.
Second, the tax authority essentially acts as another corporate monitor, similar to a public accounting firm. This additional source of oversight can lead to improved firm performance, especially in small and midsized firms, which generally lack such monitors. Since banks are generally more willing to lend to better performing firms, this again suggests that greater tax enforcement may induce more bank lending.
Tax enforcement may also improve average loan quality. By improving the accuracy of the information used in the lending process, tax enforcement can reduce the likelihood of errors in assessing borrower creditworthiness. Furthermore, if tax enforcement induces improvements in borrower performance, the borrower should be less likely to eventually default.
On the other hand, there are also reasons to believe that tax enforcement could have no effect, or even a negative effect, on bank lending. For example, greater tax enforcement leads to greater payments to the tax authorities, and therefore reduces the borrowing firm’s cash flows and equity. If these reductions affect firms’ ability to repay loans, stricter tax enforcement could lead to less (and worse) bank lending to corporate borrowers.
To study the effect of tax authorities on the banking sector, we exploit the district-based structure the IRS employed for tax enforcement purposes until 1999. Under this system, the likelihood that a firm’s tax return would be audited depended in part on the IRS district in which the firm was located. Using bank regulatory filings, we can observe a subset of banks that have the vast majority of their operations within a given IRS district. By examining these regional banks, we focus on banks whose corporate borrowers are primarily local businesses, allowing us to identify the tax return audit rate that likely impacted the bank’s existing and potential borrowers.
Furthermore, we focus on tax enforcement efforts aimed at small and midsized corporations (those with assets between $10 and $50 million). These firms are more likely to be funded by bank debt because of their relative lack of access to equity and public bond markets. Small and midsized firms are also less likely to produce audited GAAP financial statements and most of these firms are not covered by analysts or other potential monitors, suggesting that the incremental effects of tax authority oversight could be important. Thus, the tax enforcement efforts aimed at these firms may be especially relevant for bank lending.
Our study finds that greater tax enforcement aimed at small and midsized firms leads to increased commercial lending. Specifically, we find that a one percentage point increase in the tax return audit rate for these firms leads to an increase of $1.2 million in commercial lending by the average bank. Furthermore, we find that greater tax enforcement leads to improved loan portfolio quality, suggesting that tax enforcement improves banks’ ability to accurately evaluate the creditworthiness of potential corporate borrowers.
While the typical motivation for greater tax enforcement is to increase tax revenues, our study points to an unintended, positive consequence of greater tax enforcement: a banking system that makes more and better quality commercial loans. Our findings should be of interest to both tax authorities and bank regulators, as they suggest that the tax authorities’ mandates have important implications on the performance and stability of the banking sector. While tax enforcement is not costless, and any benefits must be weighed against those costs, our results suggest that there are previously undocumented “tax enforcement spillovers” that should be considered.
You can find our study here.
John Gallemore is an Assistant Professor of Accounting at the University of Chicago Booth School of Business and Martin Jacob is a Professor of Business Taxation at WHU – Otto Beisheim School of Management.
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