How to Tax Family Firms

Project Active from to State and Tax

We propose a framework for analyzing tax policy in a context when firms employ relatives (or other trusted individuals) to reduce agency costs. Our focus is on implications for the design of the tax base. We show that, if feasible, pure profit tax is optimal under natural assumptions. However, the key feature of agency costs is that they need not be observable and hence pure profit tax may not be feasible. Decisions that mitigate agency costs also interact with tax evasion. For example, reliance on cash is likely to increase agency costs by making it more difficult to monitor stealing by employees and at the same time facilitate tax evasion. On the other hand, while relying on trusted individuals may make it easier to engage in tax evasion, it also makes agency costs smaller overall and thus brings tax policy that relies on observable information more in line with “ideal” profit taxation. We characterize the optimal policy implications, focusing on the intuition and the relationship to established results from the literature on optimal taxation of income. Our framework allows for considering comparative statics of our results with respect to a number of parameters that are likely to vary across countries with different levels of development such as inefficiency for employing relatives, the extent of trust, supply of trusted labor and magnitude of monitoring problems.