How tax audits can open credit floodgates: Evidence from Ecuador

Editor's Note: For more on tax audits and their impacts read the VoxDevLit on Taxation and Development. 

An unexpected and welcome side effect occurred when Ecuador decided to crack down on tax evasion over the past decade. As the South American country stepped up monitoring efforts of its largest firms, banks became increasingly willing to make loans. 

In an ideal world, banks would fund all good projects. But in the real world, caution dictates they withhold credit when they lack enough credible data to perform a risk assessment. As a result of the new audit regime, Ecuadorian lenders and investors could rely on an outside party to verify, or challenge, financial claims, including revenues and profits. As a result, banks became more willing to supply debt. What’s more, their loans have tended to be bigger and at lower interest rates than that offered to comparable, but unaudited, companies.

According to the World Bank (World Bank Enterprise Surveys 2006-2017), access to external financing is widely cited as the greatest obstacle to corporate growth, especially in developing countries. Given the experience of Ecuador, emerging markets throughout the world may wish to re-examine what, at first glance, seems an unlikely stimulus tool: the lowly tax audit. 

What happened in Ecuador?

In a recent paper (De Simone 2020) supported by a grant from the Jerome A. Chazen Institute for Global Business, I delve into a 2009 tax reform that stepped up Ecuador's audits of the largest companies in each province. More than 90 countries around the world use variations of the so-called Large Taxpayer Unit (LTU) approach (Bachas et al. 2018). In Ecuador, monitoring also extends to a target firm’s suppliers, customers, banks, and employees. What's more, the audited companies can expect such tax scrutiny annually. 

Ecuador's auditing programme served its primary purpose by helping boost government tax revenues from 3% of GDP in 2008 to 17% of GDP in 2017. The average firm monitored by the LTU paid approximately $5,500 more in annual corporate taxes, a 44% increase over the era before the enhanced audits.

Surprisingly, Ecuador's programme also helped boost audited firms' bank funding. I find that Ecuador's tax audits kicked off unexpected and robust stimuli to the economy.

• Banks lowered the cost of borrowing. Banks decreased the interest charged on loans to the audited group. For example, the average post-audit loan was almost 200 basis points lower than the rate for firms outside the programme, which averaged 13.4%.
• Loans became bigger. Firms borrowed an average of $104,010 in the year before the enhanced audits. That figure jumped to $167,000 for the average monitored firm post inclusion in the auditing programme.
• More financial institutions participated. Monitored firms became more likely to borrow from a bank they had never borrowed from before, so the risk pool was spread around a greater number of financial institutions. They were also more likely to attract investments from new private investors.
• Companies stepped up investment in human and physical capital. Monitored firms grew both their employment and physical investment. Anecdotally, I found that because audits were an annual exercise, solid companies became confident they could get loans not just immediately, but into the future. 

In short, the audits shined a bright light on companies' internal financials and appear to have reduced barriers to capital markets. 

A culture of evasion

An extensive literature (beginning with La Porta et al. 1997) documents a connection between good government institutions, capital-market access, and the cost of capital. In developed countries with well-developed institutions, firm oversight is often provided by agencies, other banks, or external auditors. Yet, in many less-developed economies, outside monitors lack monitoring skills and may be expensive, while making use of courts is slow and costly. 

Where manager fraud is common, it cuts into a government's fiscal revenues. In 2010, for example, Ecuador's tax commissioner estimated income tax evasion at approximately 45%, and avoidance of the value-added tax, mostly paid by corporations, at 21% (El Universo 2010). 

Moreover, this culture of evasion is not limited to interactions between the government and firms; it permeates the financial and real sectors as well. As a result, firm growth is limited. My research suggests that, in these situations, the government itself can act as a third-party monitor through its rule-making and enforcement roles.

To be clear, tax audits are not cheap. To monitor 5% of Ecuadorian firms, the tax authority uses around 70% of its auditing resources each year. Still, these companies also provide more than 80% of corporate tax revenues. Last year the government decided to nearly double the number of monitored firms to test how well the programme scales.

Corporate costs also rose. Not only did monitored firms pay more in taxes, they also stepped up their internal accounting areas in anticipation of the intensive audit. "Substantial" increased backroom costs can be anticipated even for companies operating in highly monitored developed countries. (For estimates of firm compliance costs following implementation of the Sarbanes-Oxley Act of 2002, a major reform to corporate accounting procedures in the US context see Iliev, 2010 and Coates and Srinivasan, 2014). What's more, a trickle-down negative may have affected some Ecuadorian suppliers and employees when audited companies dropped their off-the-book relationships. However, in my research setting, the benefits appear to outweigh the costs with Ecuadorian regulators reporting companies requesting to be included in the auditing programme.

Lessons beyond Ecuador

The policy implication for Ecuador and similar developing nations is that tax oversight can improve credit access and growth agendas.

In particular:

• Monitoring might increase transparency for private firms with little transactional history, possibly making loans more available for young corporate borrowers.
• Governments could conceivably lower tax rates without loss of revenue if the enhanced oversight brings in funds that previously leaked through fraud or sloppy accounting. 
• Compared with direct injection of funds, tax audits could provide cleaner motivation. Investors can assume most government tax authorities are auditing firms hoping to increase tax collection rather than advance political motives, such as adding employees to a public official's district or bolstering a specific industry.

Further research may show that developed economies also benefit from enhanced auditing practices. Suggestive evidence in the US context shows that tax auditing may lower the cost of issuing company debt and equity, respectively (Guedhami and Pittman 2008, El Ghoul et al. 2011).  

Increasing tax oversight can boost credit availability

In Ecuador, the stimulus effects of increased auditing were apparent quickly within a year of the implementation of tax reforms. As counterintuitive as it first appears, increasing tax oversight seems to create transparency regarding business financial reporting. That, in turn, boosts banking confidence and, therefore, credit availability. Access to more plentiful but less expensive loans encourages business growth, including employment. Further study of this channel appears to be worthwhile given the extensive use of Large Taxpayer Unit programmes around the world, and the concurrent benefits to governments, firms, and banks. 

References 

Bachas, P, R Jaef and A Jensen (2018), “Size-dependent tax enforcement and compliance: Global evidence and aggregate implications”, World Bank Policy Research Working Paper 8363.

Coates, J and S Srinivasan (2014), “SOX after ten years: A multidisciplinary review”, Accounting Horizons 28, 627–671.

De Simone, R (2020), “Real effects of government monitoring: Evidence from commercial bank loans”, Working Paper.

El Ghoul, S and O Guedhami and J Pittman (2011), “The role of IRS monitoring in equity pricing in public firms”, Contemporary Accounting Research, 28, 643-674.

El Universo (2010), “Evasión fiscal se ubica en un 45%,” published in the newspaper El Universo on April 26, 2010 (last accessed online 22/07/2018).

Guedhami, O and J Pittman (2008), “The importance of IRS monitoring to debt pricing in private firms”, Journal of Financial Economics 90, 38–58.

Iliev, P (2010), “The effect of SOX section 404: Costs, earnings quality, and stock prices”, The Journal of Finance, 65, 1163–1196.

La Porta, R, F Lopez-de Silanes, A Shleifer and R Vishny (1997), “Legal determinants of external finance”, The Journal of Finance, 52, 1131–1150.

World Bank Enterprise Surveys, 2006-2017, World Bank Microdata Library.