The United States has dramatically slashed the budget of the Internal Revenue Service, hindering its ability to conduct audits. ProPublica and the Atlantic reported in December 2018 that the number of IRS auditors had fallen to levels not seen since 1953.

These cutbacks naturally lead to less tax collection and government revenues, but research indicates another, unexpected drawback. Fewer audits of small- and medium-sized businesses may leave banks less willing to make loans, according to Chicago Booth’s John Gallemore and WHU—Otto Beisheim School of Management’s Martin Jacob. And as bank lending is a main source of capital for small and midsize companies, the findings have implications for economic growth.

Drawing on data from the IRS and regional banks, Gallemore and Jacob studied the annual growth in commercial loans among regionally focused banks, which frequently lend to local small and midsize businesses. They used bank regulatory filings to isolate lenders with a heavy branch presence in a given IRS district, and then matched the district-level audit rate for small and medium businesses with growth in commercial lending by district.

They find that a 1 percent rise in the district-level audit rate was associated with a quarter-percent increase in commercial-lending growth. The effect was stronger for banks that did some commercial lending but did not specialize in it. It was also stronger for banks facing less competition, which suggests that tax enforcement particularly increased lending in areas with fewer banks.

More audits were also associated with an improvement in loan-portfolio quality, based on lower loss provisions and fewer write-offs.

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Banks can use data in tax returns to assess borrowers’ creditworthiness, as well as to validate information from other sources, including company financial statements. Thus, stepped-up scrutiny of corporate returns can increase banks’ confidence in tax documents, making banks more likely to approve a loan. Additionally, when lending institutions know that the IRS and other agencies are closely inspecting corporate tax returns, banks may be able to reallocate resources away from verifying information submitted by loan applicants and toward identifying additional potential borrowers.

This shift may expand the volume of loans granted, helping economic growth. The researchers find evidence suggesting that in counties with above-median exposure to commercial lending, more audits may produce more lending—and more jobs. “We think these results are consistent with the story that tax enforcement leads to greater bank commercial lending, which in turn leads small and midsize firms to hire more,” says Gallemore.

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