Dynamic Contracting and Corporate Tax Strategies

35 Pages Posted: 1 Jul 2024

See all articles by Juan Felipe Imbet

Juan Felipe Imbet

Université Paris Dauphine - Department of Finance

Marcelo Ortiz M.

Universitat Pompeu Fabra; Universitat Pompeu Fabra - Barcelona School of Management; Barcelona School of Economics

Vincent Tena

Université Paris Dauphine

Date Written: June 21, 2024

Abstract

We use a dynamic moral hazard model in which a firm's owner delegates the corporate tax strategy to an agent in an institutional setting with random inspections by tax officers. The principal cannot observe the underlying gross profits or the agent's efforts to reduce tax expenses. The inspection is random and may not occur. Upon inspection, illegal strategies are detected and penalized, however, the authorities cannot observe how much was evaded. The optimal dynamic contract consists of a terminal compensation and a tax reduction strategy. We find that even in contexts without inspections, a risk-averse owner will not contract tax strategies if the agent's effort costs or the gross profit volatility are too high to compensate for risk aversion. For contexts with inspections, the optimal compensation includes an additional risk premium for bearing the inspection risk and a lump-sum loss contingent on an inspection. The optimal tax strategy becomes less aggressive over time as the expected penalty increases. The dynamic nature of the model allows for quantitative evaluations. Using calibrated parameters from corporate taxation in the U.S., the model indicates that the agent's compensation corresponds to 37.8% of the expected benefits derived from the tax strategy.

Keywords: continuous-time contracting, contract theory, tax strategy, tax evasion JEL Codes: D82, D86, H21, H26, M52

Suggested Citation

Imbet, Juan Felipe and Ortiz M., Marcelo and Tena, Vincent, Dynamic Contracting and Corporate Tax Strategies
(June 21, 2024). Available at SSRN: https://ssrn.com/abstract=4872375 or http://dx.doi.org/10.2139/ssrn.4872375

Juan Felipe Imbet

Université Paris Dauphine - Department of Finance ( email )

Place du Maréchal de Lattre de Tassigny
Paris Cedex 16, 75775
France

Marcelo Ortiz M. (Contact Author)

Universitat Pompeu Fabra ( email )

Barcelona
Spain

HOME PAGE: http://www.marceloortizm.com

Universitat Pompeu Fabra - Barcelona School of Management ( email )

Barcelona, 08005
Spain

Barcelona School of Economics ( email )

Ramon Trias Fargas, 25-27
Barcelona, Barcelona 08005
Spain

Vincent Tena

Université Paris Dauphine ( email )

Place du Maréchal de Tassigny
Paris, Cedex 16 75775
France

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