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Dodging the Taxman: Firm Misreporting and Limits to Tax Enforcement

Pro­gram ar­eas

Po­lit­i­cal Econ­o­my and Gov­er­nance, Pub­lic Fi­nance, Po­lit­i­cal Econ­o­my

Out­line

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.

Re­search Team

Author

Dina Pomeranz

Assistant Professor of Microeconomics, endowed by the UBS Center

Zurich ZCED

Mon­i­ca Sing­hal

Har­vard Uni­ver­si­ty

Paul Car­ril­lo

George Wash­ing­ton Uni­ver­si­ty

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