Why do firms evade taxes? We tackle this question by studying firms in the formal sector operating in countries with different institutional backgrounds, and comparing the incentives and constraints of staying within the formal sector against the competitive pressures originating from the informal sector. We argue that it is the combination of these factors that largely explains formal firms’ tax evasion decisions. Our findings highlight the dark side of competition, particularly when it originates from perceivably unfair sources (i.e. from the informal sector). We also shed light on how this effect is moderated by the institutional conditions of the environment.
In international business, the institution-based view asserts that firm behaviors around the world are affected by the rules of the game—specifically institutions that govern the “do’s” and the “don’ts” (Dunning & Lundan, 2008; North, 1990; Peng, Ahlstrom, Carraher, & Shi, in press; Peng, Wang, & Jiang, 2008). However, not all firms comply with all the rules and regulations. Instead, corporate misconduct is frequent around the world. One of the most ubiquitous illegal corporate behaviors in almost every country is corporate tax evasion, which is defined as a managerial decision not to fully report taxable corporate profit in order to reduce tax payments (Sandmo, 2005).1 Past research has identified several factors that influence the likelihood of corporate tax evasion (Andreoni, Erard, & Feinstein, 1998), such as public sector corruption (Friedman, Johnson, Kaufmann, & Zoido-Lobaton, 2000; Goerke, 2008), tax rates (Cowell, 2004; Fisman & Wei, 2004), degree of penalties (Gordon, 1990), fairness of the tax code (Cullis and Lewis, 1997), and effectiveness of corporate governance mechanisms (Desai & Dharmapala, 2006; Desai, Dyck, & Zingales, 2007). However, the interplay between formal and informal firms is underexplored in the literature (Mathias, Lux, Crook, Autry, & Zaretzki, 2015). Due to significant variations in the prevalence of the informal economy across countries, international business (IB) research would benefit from a better understanding of the dynamics of competition between these two groups of firms, and the resulting effects on formal firms’ tax compliance decisions.