Corporate tax reform has been a big topic of conversation among economists here in the U.S. with the passage of the recent tax bill on Capitol Hill. Proponents argued that lowering the corporate tax rate from 35 to 20 percent would increase U.S. competitiveness and increase after-tax profits for corporations and in turn increase investments and returns to labor.
A large component of the discussion surrounding the corporate tax rate in developed, wealthy nations revolves around international tax competition and large multinational firms with the capacity to move their operations across borders to take advantage of lower tax structures (see Devereux and Loretz, 2012, for a review of the relevant literature on tax competition). Much of the study of corporate taxes has been based in these high enforcement settings and has been a study of corporate firms.
Setting appropriate tax rates is arguably more challenging in developing countries with low enforcement and large informal sectors. In these settings firms (noncorporate firms in particular) have two additional methods of responding to changes in the tax rate: they can move into the large existing informal sector, thereby reducing the overall tax base, or they can engage in tax evasion, given the low enforcement capabilities of the government. Evidence from these settings can be informative as to the elasticity of noncorporate firms to tax rates in a setting that is distinct from that of developed countries where there are fewer tax evasion opportunities. Waseem (2017) recently published a paper in the Journal of Public Economics ("Taxes, Informality, and Income Shifting: Evidence from a Recent Pakistani Tax Reform") analyzing firm responses to an increase in the tax rate for noncorporate firms in Pakistan that looks at this issue.
He finds that the responses by firms to the tax reform were so large that the Pakistani government was collecting less in in revenue three years after the reform than it was prior to the reform. On the intensive margin, firms impacted by the increase in tax rate were reporting significantly smaller earnings. On the extensive margin, fewer firms were registered with the government and reporting positive profits, indicating a shrinking of the formal tax base.
The policy in question was enacted by the Pakistani government in 2009 and raised the tax rate on partnerships from a bracketed system with average tax rates that varied progressively from 0% to 25% (a tax rate that continued to be applied to sole proprietorships) to a flat tax rate of 25%. This change was enacted in order to reduce the variation in tax rate between partnerships and corporate firms, the latter of which was taxed at and remained taxed at 35% after the tax reform, and to reduce the disincentives for incorporation of new firms.
The implications of this study for developing countries are stark. Policies such as this one need to account for the "unintended" effects of tax reform on formalization and tax evasion as well as the intended effects on incentives to incorporate. High variation in the tax rates across noncorporate firms in this particular case (specifically between partnerships and sole proprietorships) led to significant levels of tax evasion, income shifting, and movement into informality that counteracted higher tax revenues collected from the partnership firms still remaining in the formal tax base and from incorporated firms.
Estimation strategy
The author employs a difference-in-differences method to take advantage of the tax reform in Pakistan in 2009. He uses administrative data of income tax returns filed from 2006-2011 to compare the outcomes of partnership and non-partnership firms (corporations and sole proprietorships): log change in reported earnings and log change in the number of filers. The former represents the intensive margin response of firms that remained in the tax base and the latter the extensive margin response of firms that exited the tax base.
The model estimated for the intensive margin elasticity is:
This regresses the log change in the reported earnings of a firm i at time t on its status as a partnership, the log change in its net-of-tax rate, a set of control variables, and year fixed effects.
To account for potential endogeneity between the change in the tax rate and change in reported earnings (i.e. not only does the change in the tax rate impact the change in reported earnings but reported earnings also impacts the tax rate), the author uses an instrumental variables strategy regressing the change in the tax rate on a dummy variable for whether the observation is a partnership firm in the post-reform period in a first-stage regression that allows him to isolate the variation in the tax rate change that is due to the tax reform for partnerships.
A large component of the discussion surrounding the corporate tax rate in developed, wealthy nations revolves around international tax competition and large multinational firms with the capacity to move their operations across borders to take advantage of lower tax structures (see Devereux and Loretz, 2012, for a review of the relevant literature on tax competition). Much of the study of corporate taxes has been based in these high enforcement settings and has been a study of corporate firms.
Setting appropriate tax rates is arguably more challenging in developing countries with low enforcement and large informal sectors. In these settings firms (noncorporate firms in particular) have two additional methods of responding to changes in the tax rate: they can move into the large existing informal sector, thereby reducing the overall tax base, or they can engage in tax evasion, given the low enforcement capabilities of the government. Evidence from these settings can be informative as to the elasticity of noncorporate firms to tax rates in a setting that is distinct from that of developed countries where there are fewer tax evasion opportunities. Waseem (2017) recently published a paper in the Journal of Public Economics ("Taxes, Informality, and Income Shifting: Evidence from a Recent Pakistani Tax Reform") analyzing firm responses to an increase in the tax rate for noncorporate firms in Pakistan that looks at this issue.
He finds that the responses by firms to the tax reform were so large that the Pakistani government was collecting less in in revenue three years after the reform than it was prior to the reform. On the intensive margin, firms impacted by the increase in tax rate were reporting significantly smaller earnings. On the extensive margin, fewer firms were registered with the government and reporting positive profits, indicating a shrinking of the formal tax base.
The policy in question was enacted by the Pakistani government in 2009 and raised the tax rate on partnerships from a bracketed system with average tax rates that varied progressively from 0% to 25% (a tax rate that continued to be applied to sole proprietorships) to a flat tax rate of 25%. This change was enacted in order to reduce the variation in tax rate between partnerships and corporate firms, the latter of which was taxed at and remained taxed at 35% after the tax reform, and to reduce the disincentives for incorporation of new firms.
The implications of this study for developing countries are stark. Policies such as this one need to account for the "unintended" effects of tax reform on formalization and tax evasion as well as the intended effects on incentives to incorporate. High variation in the tax rates across noncorporate firms in this particular case (specifically between partnerships and sole proprietorships) led to significant levels of tax evasion, income shifting, and movement into informality that counteracted higher tax revenues collected from the partnership firms still remaining in the formal tax base and from incorporated firms.
Estimation strategy
The author employs a difference-in-differences method to take advantage of the tax reform in Pakistan in 2009. He uses administrative data of income tax returns filed from 2006-2011 to compare the outcomes of partnership and non-partnership firms (corporations and sole proprietorships): log change in reported earnings and log change in the number of filers. The former represents the intensive margin response of firms that remained in the tax base and the latter the extensive margin response of firms that exited the tax base.
The model estimated for the intensive margin elasticity is:
Δlog zit =α+β Partnershipi +ε Δlog(1−τit)+Xi δ+λt +uit
To account for potential endogeneity between the change in the tax rate and change in reported earnings (i.e. not only does the change in the tax rate impact the change in reported earnings but reported earnings also impacts the tax rate), the author uses an instrumental variables strategy regressing the change in the tax rate on a dummy variable for whether the observation is a partnership firm in the post-reform period in a first-stage regression that allows him to isolate the variation in the tax rate change that is due to the tax reform for partnerships.
