Financial and Real Effects of Government Monitoring: Evidence From Commercial Bank Loans

Abstract

I use a 2009 redesign of the Ecuadorian government's corporate tax auditing to document that tax enforcement affects firms' cost of capital and real decisions in settings where agency frictions constrain lending. Firms included in a group that was disproportionately monitored, i.e., audited annually by the Ecuadorian tax authority, accessed significantly cheaper new bank debt despite paying more taxes. Additionally, monitored firms increased their investments in human and physical capital. I use a regression discontinuity design to control for selection bias in their decision about which firms to monitor. Finally, I provide evidence that tax enforcement reduces agency frictions between the firm and its lenders, which is reflected in the lower interest rate on new debt. The implications are that (1) credible tax enforcement by the government can play a corporate governance role, and, (2) tax enforcement is an effective and fiscally positive way to stimulate firm investment where agency frictions constrain lending.