Can a Larger Number of Tax Audits Generate Economic Growth?

Martin Jacob / John Gallemore - March 17, 2021

Tips for practitioners

In the United States, spending on the Internal Revenue Service (IRS) has been massively curtailed in recent years, with a direct consequence being that the number of auditors active is currently at its lowest since 1953. With its effective protection against taxevasion having been eroded, the government can expect to see lowertax revenues.

Fewer audits mean lower tax revenues—and that’s not all

The significantly lower audit rate for small and medium-sized enterprises (SMEs) is having another impact that is not immediately apparent: Regionalbanks have become less willing to lend to them. For such financial institutions, the results of these audits, which show how much corporatetax has been paid, are a strong indication of whether a business is operating soundly or, conversely, facing a potential downturn. If the number of audits decreases, the banks lose a piece of information crucial for assessing a company’s creditworthiness.

Better tax audits increase willingness to lend

In the United States, the year 1999 marked a decisive turning point in tax enforcement: Before the turn of the millennium, companies had previously been audited by the regional tax offices. In 2000, the American tax apparatus was centralized in Washington, D.C., from where audits are also now commissioned. This was accompanied by a sharp decline in the IRS budget over the following years, causing a shortage of tax auditors. This meant that tax audits could only be carried out less consistently and comprehensively.

The years prior to 1999, when business taxes were still audited by regional IRS offices themselves, are of particular interest. Small regional banks are particularly important to SMEs as they make up their main lenders. In some cases, due to their size, these banks do not always have the necessary data to grant them loans without incurring major risks. If, in these cases, audits are greatly reduced as a result of cost-cutting measures, banks will lack access to crucial information. It will be more difficult for them to determine whether the companies in question are likely to default on payments and how profitable they actually are. They tend to remain cautious when granting commercial loans, a crucial source of financing for SMEs.

Conversely, more tax audits at SMEs produce a better factual basis and therefore facilitate lending decisions. Prior to 2000, a 1% increase in company audits in one region led to an increase of 0.25% in lending to SMEs. A comparison with other regions (where the budget had remained as it was) made it clear that this effect was largely due to the increased quality and quantity of tax audits.

Further results of having more tax audits

The principle of frugality does not quite apply when it comes to reducing the number of tax inspectors: First, more audits can uncover more tax evasion and thus increase tax revenues. Second, regular audits of SMEs provide regional banks important information that would be unavailable with a less thorough auditing approach. As it stands, banks have to cope with a greater level of uncertainty when approving loans. Better tax audits also benefit the companies and positively affect them in a number of ways. For example, the more readily companies can obtain loans, the more streamlined their planning and investment strategies will be. This, in turn, generates economic growth in the region in question and ultimately leads to higher employment rates. The number and quality of audits carried out goes beyond combating tax evasion; it also influences the prosperity of an entire region.

Literature references and methodology

In the study “Corporate Tax Enforcement Externalities and the Banking Sector”, researchers Professor Dr. Martin Jacob of WHU – Otto Beisheim School of Management and Professor Dr. John Gallemore of the University of Chicago examined the impact of tax enforcement aimed at SMEs on bank lending. The researchers focused primarily on the years before 1999 when the audits of corporate tax returns were organized at the regional level in the U.S. The regional differences and the detailed bank-level data provided an extensive data basis for this study:

• Gallemore, J./Jacob, M. (2020): Corporate Tax Enforcement Externalities and the Banking Sector, in: Journal of Accounting Research, 58(5), 1117–1159.

Further reading

• Daks, M. (2019): Would more corporate tax enforcement lead to more lending?, in: Chicago Booth Review.