Real Effects of the Enforcement of Anti-Avoidance Regulation

Abstract

We examine, in a game-theoretic model, how anti-avoidance regulation and a strategic tax auditor affect a firm’s investment and tax-avoidance decisions. Our model investigates a firm that decides on investment and tax avoidance. In contrast to previous theoretical studies, our analysis incorporates a strategic tax auditor, who observes the firm’s pre-tax profit and the effective tax rate, and decides on audit effort. Our analysis identifies the equilibrium and studies how enforcement variations affect the firm’s tax avoidance and investment. We find that the presence of the strategic tax auditor, in equilibrium, leads to over- or underinvestment. Although stronger enforcement—stricter anti-avoidance regulation, higher-powered tax auditor incentives, or higher enforcement costs for the firm—mitigates tax avoidance, the impact on investment is ambiguous. Our results show that stronger enforcement can either exaggerate or mitigate investment inefficiencies and thus has real effects.

Keywords: tax avoidance, investment, real effects, strategic tax auditor

JEL Classification: H26, H87, M42