Financial Contracting with Tax Evaders

Abstract

This paper derives the optimal financial contract when an entrepreneur can evade taxes in a model of costly state verification. In contrast to previous literature on costly state verification and financial contracting, we find that standard debt contracts are not optimal when tax evasion is possible. Instead, the optimal contract is debt-like only for very low and very high profit realizations, and features a constant repayment and verification of returns in an intermediate range. This occurs because the entrepreneur has to be given a positive rent even under verification in order to not abuse her limited liability protection for excessive tax evasion activities.

Keywords: Financial Contracting, Security Design, Corporate Tax Evasion, Costly State Verification

JEL Classification: D82, D86, G3, H25, H26