Tax evasion limits the development of fiscal capacity, distorts the allocation of resources in the economy, and can result in a reliance on economically inefficient tax instruments. Recent studies have shifted emphasis from the traditional idea of tax enforcement through auditing toward a focus on “third- party information”: the ability to verify taxpayer reports against other sources, such as an employer report of salary or the report of a firm’s trading partners. Third-party information is central to modern tax collection in developed countries, and the global revolution in information technology has made third-party verification easier than ever before. Improvements in third-party information would appearto have the potential to transform tax collection, particularly in developing economies.
Evidence from experiment in Ecuador
In this study, we show a fundamental limit to the effectiveness of third-party information in improving revenue collection: the ability of taxpayers to make offsetting adjustments on less verifiable margins of the tax return. We demonstrate that this behavior can be expected under conditions common in many developing countries, where capacity on other dimensions of the information and enforcement environment are weak. We provide strong empirical evidence of such adjustments in the context of a natural experiment in Ecuador, in which the tax authority notified firms about discrepancies between their declared revenues and revenue reports from third-party sources. Firms increase reported revenues in response to the notifications but offset almost the entire adjustment with increases in reported costs, resulting in only minor increases in total tax collection.
Our results highlight the importance of other aspects of the enforcement environment in determining the effectiveness of third-party reporting. From a policy perspective, our results indicate that third-party reporting alone is unlikely to provide an easy and immediate solution to the problem of improving fiscal capacity in low-income economies. This does not necessarily mean that countries should not invest in information technologies that support third-party reporting. Indeed, third-party reporting could be a powerful tool for tax collection as the scope of transactions covered by third-party reporting expands and the ability to monitor and enforce compliance on non-third-party reported margins increases.