Political Connections, Corruption, and Tax Practices

  • Hichem KhlifEmail author
  • Ines Amara
Living reference work entry
DOI: https://doi.org/10.1007/978-3-319-31816-5_3617-1

Synonyms

Tax aggressiveness: an aggressive form of tax avoidance or tax management.

Tax shelters: techniques used by taxpayers to decrease their taxable incomes (e.g., investing in exempt sectors or a tax haven).

Definitions

Political connections may take several forms including the presence at least of one politician (e.g., a member of parliament, a minister, a president, a king, and any other top appointed bureaucrat in the government), in firm’s ownership structure, board of directors or audit committee.

Corruption is defined as an act in which one agent typically pays a sum of money or performs a service in exchange for an illicit act by a public official (Picur and Riahi-Belkaoui 2006).

Tax evasion is defined as the illegal practices to escape from taxation that can occur in an isolated incident within the activity or in the informal economy where the whole activity takes place in an informal manner (Picur and Riahi-Belkaoui 2006).

Tax avoidance occurs when taxpayers use the legal scope for the discretion of tax laws running counter the purpose of tax legislation (Kim and Zhang 2016).

Introduction

Tax evasion, political connections, and corruption are important current issues for governments worldwide. Understanding the effect political connections and corruption on aggressive tax practices have been gaining momentum in tax, accounting, and economic literatures (e.g., Alm et al. 2016; Kim and Zhang 2016; Lin et al. 2017). Accordingly, it becomes important to summarize this literature to help policymakers in quantifying the adverse effects of political connections and corruption on tax practices and implementing adequate fiscal strategies in order to reduce their damaging impacts on tax revenues collection.

To do so, this chapter surveys the recent literature examining the association between political ties, corruption, and tax compliance. Fifteen published empirical studies (Articles dealing with the link between political connectedness, corruption, and tax compliance are located by searching keywords e.g., political connections, corruption and tax avoidance, tax aggressiveness, tax evasion, tax enforcement in the most relevant social science research data bases such as Emerald, JSTOR, Science Direct, Springer, Wiley Blackwell.) are identified over the period of 2006 to beginning of 2018 conducted in developed, developing and emerging economies using either single-country analysis or cross-country investigation.

This literature review reveals that both political connections and corruption have an adverse effect on tax compliance. On the one hand, political connectedness is associated with increased tax aggressiveness in developed (e.g., USA), developing (e.g., China, Malaysia), and emerging economies (e.g., Tunisia) through lower effective tax rates, higher tax sheltering, increased tariff evasion, and reduced tax enforcement exerted by fiscal authorities. On the other hand, corruption level implies higher tax evasion levels, mitigates the negative effect of sustainability level on tax evasion, increases the positive effect of financial crime on tax noncompliance, and increases tariff evasion (e.g., tariff rates, values, and quantity gaps).

This review integrates and analyzes a broad spectrum of tax literature dealing with the impact of political connections and corruption on tax compliance. In light of increased global efforts to fight tax evasion and aggressive tax practices, an updated literature review with an international perspective is needed to inform the regulatory debate surrounding the enactment of new legislations that may reduce the adverse effect of political connections and corruption on tax compliance. This review is also relevant to academics interested in the determinants of tax compliance since it suggests areas where further research around political connection, corruption, and tax evasion is needed.

The rest of the chapter is organized as follows. Section “Political connections and tax practices” reviews the empirical literature examining the impact of political ties on different tax practices. Section “Corruption and tax practices” surveys empirical studies investigating the relationship between corruption and tax compliance. Section “Conclusion” concludes the chapter.

Political Connections and Tax Practices

Political connections of taxpayers may adversely influence the state’s revenue-generation efforts through direct impacts, via tax evasion or tax avoidance, and through indirect effect such as reducing voluntary tax compliance due to the destruction of tax morale of country’s citizens (Kim and Zhang 2016; Lin et al. 2017). This discussion summarizes the extant empirical literature by focusing on developed, developing, and emerging economies.

Developed Economies

Two empirical studies dealing with political connections and aggressive tax management conducted in US setting are identified. Kim and Zhang (2016) test for the association between corporate political connections and tax aggressiveness. They document that politically connected firms are more tax aggressive than nonconnected firms. Francis et al. (2016) refine the analysis by focusing on the association between CEO political connections preference in US setting (Republican CEOs versus Democratic CEOs) and tax sheltering, as an alternative proxy for tax aggressiveness. They provide evidence that Republican CEOs are associated with more corporate tax sheltering even when their wealth is not related to that of shareholders and when corporate governance is weak. They also show that Democratic CEOs are associated with more corporate tax sheltering only when they have stock-based incentives.

These findings confirm that politically connected firms may undertake more aggressive tax management since they have “lower detection risk, better information regarding future changes in tax regulation or enforcement, lower capital market pressure for transparency, lower political costs associated with aggressive tax planning, and higher risk-taking tendencies”(Kim and Zhang 2016, p. 79).

Developing Economies

On the one hand, Adhikari et al. (2006) posit that political connectedness may give managers incentives to use their discretions in order to commit illegal behavior such as concealing taxable income or profit by deliberately overstating deductions, exemptions, or credits. Managers undertake these illegal acts since they know that they are protected from any type of future law suits given their strong political ties. From an empirical standpoint, Adhikari et al. (2006) investigate the relationship between effective tax rates and political connections in Malaysia and find that firms with political connections pay taxes at significantly lower effective rates than other firms. In the same setting, Abdul Wahab et al. (2017) investigate the relationship between political connections and corporate tax aggressiveness. Based on a sample of 2,538 firm-year observations over the period of 2000–2009, they find that politically connected firms are more tax aggressive than nonconnected firms. In China, Li et al. (2016) use the occasion of increase in tax rate for several listed companies in the Chinese stock exchange and document that only politically connected firms undertake aggressive tax-induced earnings management.

On the other hand, political connections may constrain the effort played by tax authorities in the detection of fiscal infractions and the magnitude of postaudit adjustments and sanctions (Lin et al. 2017). The presence of a politician as major owner or a key actor in the management may reduce fiscal authorities’ capability to enforce tax law and strictly punish committed fiscal frauds (Lin et al. 2017). In this regard, Lin et al. (2017) test whether political connections on boards of directors weaken the effectiveness of tax authorities in constraining aggressive tax practices in China. They document that political connections reduce the effective enforcement of tax compliance by State fiscal authorities. These results imply that political connections play an adverse effect on the enforcement of fiscal legislations and reduce the capability of State fiscal authorities to collect tax revenues.

Emerging Economies

Rijkers et al. (2015) focus on the question of political connections and tariff evasion in an emerging country, namely, Tunisia. They use customs data dealing with imports realized by companies connected with 114 individuals, including Ben Ali himself and his relatives, when he was ruling Tunisia over the period (1987–beginning of 2011). They document that (i) Ben Ali-connected firms are more likely to falsely declare imports as being destined for re-exportation in order to benefit from duty exemptions and that (ii) evasion gaps are increasing with the share of importers that were politically connected. These findings suggest that trade facilitation through the rise of duty suspension regimes may increase custom duties tax evasion in emerging economies for politically connected firms.

Accordingly, relationship-based economies in emerging economies may create a favorable environment that contributes to the development of black economy size where the main operators feel protected from any future fiscal sanctions given their strong relationships with politicians in the government. Black and unofficial economies will gain momentum in such emerging economies where customs and tax officials have a hidden protection of politicians when helping them to evade the payment of taxes and customs duties.

Corruption and Tax Practices

Alm et al. (2016) suggest that corruption may reduce the value of public inspection. In countries characterized by high levels of corruption, it is difficult to reveal illegal acts committed by taxpayers using financial media. Furthermore, high corrupt environment may reduce public scrutiny and decrease the ability of fiscal administration to enforce tax legislations and punish taxpayers and their companies involved in aggressive tax practices. This implies a fertile ground for shadow activities and underground economy. This section surveys the extant empirical literature by focusing on cross-country studies and single setting empirical enquiries.

Cross-Country Studies

Six studies dealing with the effect of corruption level on tax evasion are identified. For instance, Picur and Riahi-Belkaoui (2006) examine the effect of corruption level on tax evasion for a sample 30 developed and developing countries. They find that higher corruption levels is associated with higher levels of tax evasion. Alon and Hageman (2013) test for the association between corruption and firm tax compliance in transition economies. Using a sample of 5,000 firms from 22 former Soviet Bloc transition countries, they show that higher levels of corruption are associated with lower levels of tax compliance dealing with sales, work force, and wages. In the same vein, Alm et al. (2016) investigate how specific type of corruption (bribery of tax officials) affects firm’s tax evasion practices for a sample of 8,000 observations from 32 different countries. They document that the presence of tax inspectors who demand bribes results in a reduction of sales reported for taxes between 4 and 10 percentage points and that larger bribes imply higher levels of evasion. Khlif et al. (2016) test for the moderating effect of corruption level on the association between sustainability level (Sustainability level is proxied by social, environmental scores and the quality of infrastructure) and tax evasion for a sample of 65 developed and developing countries. They provide evidence that the negative associations between sustainability proxies and tax evasion become insignificant for high corrupt countries. Worku et al. (2016) examine whether corruption level in sub-Saharan African (SSA) countries is associated with tariff evasion (e.g., tariff rates, values and quantity gaps). Using trade data from 2008 to 2014 of 31 SSA countries, they document that the interaction between (i) tariff rate, (ii) corruption in the importing country, and (iii) corruption in the exporting country is positively and significantly related to the trade gap. These findings imply that tariff evasion is reinforced by the corruption levels in both importing and exporting countries. Finally, Khlif and Amara (2018, forthcoming) investigate the association between financial crime and tax evasion and whether corruption level moderates such a relationship. Based a sample of 120 countries, they provide evidence that the level of financial crime is positively associated with tax evasion and this relationship is more pronounced for high corrupt environments.

Overall, it seems that corruption has an adverse effect on tax compliance behaviors. Countries characterized by high levels of corruption may create a fertile ground for tax noncompliance and illegal acts among their companies and taxpayers which translate into high levels of tax evasion. Accordingly, combating this phenomenon is crucial to improve tax revenues and enhance tax morale among taxpayers in one country.

Single-Country Studies

Two studies examining the effect of corruption on tax compliance behavior conducted in an emerging economy and US setting are reviewed. In an emerging economy, namely, Jordan, Alasfour et al. (2016) use a questionnaire survey to examine how the extent of governmental corruption may affect tax evasion practices. They document that the intention of surveyed taxpayers to commit tax evasion increases with the level of perceived corruption.

In US setting, DeBacker et al. (2015) examine the association between corruption norms overseas and tax evasion. More specifically, they test whether companies controlled by foreign investors resident in countries characterized by high corruption levels are more likely to evade US taxes. They find that corporations with owners from countries with higher corruption norms engage in higher amounts of tax evasion in the US setting.

In sum, the findings reported in these empirical studies suggest that the effort played by governments to reduce the extent of governmental corruption may increase tax compliance and enhance tax morale among citizens.

Conclusion

This chapter summarizes the empirical literature dealing with the impact of corruption and political connections on tax compliance by reviewing published empirical studies over the period of 2006–beginning of 2018. This review suggests that relationship-based economies based either on political connections or corruption practices may increase the scope of back economy and tax evasion. Therefore, it becomes crucial for policy makers and fiscal authorities in emerging, developing, and developed economies to identify and quantify the impact of political ties and corruption practices on taxpaying behavior. By doing so, these countries may increase the revenue-generating opportunities and improve tax morale among citizens.

Future research may explore the effect of foreign political connections on tax evasion practices, tax avoidance, and tax aggressiveness at country and company levels, subject to the availability of reliable cross-country data. In addition, future empirical enquiries may examine the impact of different types of companies’ political connections (e.g., opposition parties versus ruling parties in democratic regimes) on aggressive tax practices (e.g., tax evasion, tax aggressiveness) and compare between them. Finally, future research may also explore the possible interaction between corruption level and political connections in shaping tax evasion practices.

Cross-References

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Copyright information

© Springer International Publishing AG, part of Springer Nature 2018

Authors and Affiliations

  1. 1.Faculty of Economics and Management of MahdiaUniversity of MonastirMonastirTunisia
  2. 2.Faculty of Economics and Management of SfaxUniversity of SfaxSfaxTunisia