2009): “Why Can Modern Governments Tax So Much? An Agency Model of Firms as Fiscal Intermediaries,” NBER Working Paper 15218

This paper presents a simple agency model to explain why third-party information reporting by firms dramatically improves tax enforcement. Modern firms have a large number of employees and carry out complex production tasks, which requires the use of accurate business records. Because such records are widely used within the firm, any single employee can denounce collusive tax cheating between employees and the employer by (accidentally or deliberately) revealing the true records to the government. We show that, if a firm is large enough, this threat will make tax enforcement successful even with low penalties and low audit rates. We embed this agency model into a macroeconomic growth model where firm size grows with exogenous technological progress. In early stages of development, firms are small, tax rates are severely constrained by enforcement, and the size of government is too small. As firm size increases, the enforcement constraint is slackened, and government size is growing. In late stages of development, firm size is sufficiently large to make third-party tax enforcement completely effective and government size is socially optimal. Therefore, economic development relaxes the tax enforcement constraint and naturally leads to large welfare state governments. We show that these theoretical predictions are consistent with a set of stylized facts on the cross-sectional and time series relationship between development and the size and composition of the tax take