Taxation and Incomplete Contracts

This paper analyzes the impact of taxation on economic effciency when contracts are incomplete. We assume firms operate in a perfect competitive market and can choose between integrated or non-integrated governance to cope with contract incompleteness. Taxation reduces incentives to pursue intra-firm coordination, thus the effciency of firm's production process under non-integration. This is not the case under integration, since production decisions are transferred to the Headquarters, at a fixed integration cost. Taxation may then induce firms to change their organization at the industry equilibrium. We show that a tax that induces firms to choose integration rather than non-integration may serve a corrective function if integration costs and market prices are not too high.