Developing economies are typically characterized by low tax revenue and widespread tax evasion. This research shows that in such environments, it can be better to tax firms based on turnover rather than profits: while turnover taxes are known to distort production decisions, they are more difficult to evade than profit taxes. Analyzing administrative tax records from Pakistan, the study shows that the use of production-inefficient turnover taxes sharply reduces tax evasion and increases tax revenue.
Raising tax revenue is a key challenge for developing countries. The Sustainable Development Goals launched by the United Nations in 2015 recognize this and call on governments to ‘strengthen domestic resource mobilization, including through international support to developing countries, to improve domestic capacity for tax and other revenue collection.’
In low-income countries, governments typically struggle to raise sufficient tax revenues to provide essential public goods and services. Pakistan, for example, raises only 13% of its GDP in tax revenue and has fewer than 30,000 tax-filing corporations registered. In contrast, the UK raises 38% of its GDP in tax revenue and has over a million tax-filing corporations registered.
The low tax take in developing countries is largely due to weak enforcement. Where informal sectors and the cash economy are dominant, taxable economic activities are easily hidden and don’t leave behind verifiable information trails, such as receipts, bank records and credit card information. Audits are few in number and poorly targeted – partly because of the weakness of information trails – and tax evaders are rarely caught, let alone punished.
The prescriptions of traditional tax theory
What should tax policy look like in an environment of weak enforcement? In particular, how should businesses be taxed?
One of the most celebrated results in public finance theory – the ‘production efficiency theorem’ of Diamond and Mirrlees (1971) – dictates that taxes should not distort how goods are produced, though they may distort which goods are consumed. This implies that governments can tax wages, consumption and profits, but that they should not tax intermediate inputs, trade or turnover.
Pakistan’s turnover tax reduces evasion by as much as 60-70% of corporate income compared with the profit tax
This theoretical result has been central to much of the tax policy advice given to developing countries. But the result relies critically on perfect enforcement – zero evasion at zero administrative costs – an assumption that is clearly violated in countries with large informal sectors.
So how should policy-makers design tax policy when facing high levels of evasion? In recent research, we try to break new ground in the analysis of this question.
A trade-off between production efficiency and revenue requirements
Our study begins by developing a model of optimal tax policy in which firms may under-report their tax liability. In the model, the government sets both the tax rate and the tax base applying to firms. The tax base can be either profits or turnover – or it can be a hybrid of the two. Moving towards a broader turnover tax base (with fewer permissible deductions than a profit tax) gives firms fewer opportunities to evade. This helps the government to raise revenues, but it also distorts firms’ choices and reduces production efficiency.
We show that in such a context, it is optimal for the government to sacrifice some production efficiency in return for the reduced evasion that a broader tax base offers. We characterize the optimal balance of this trade-off in terms of parameters that we estimate in an empirical application to Pakistan.
Minimum taxes on turnover: an evasion-proof tax instrument?
In our empirical application, we study a tax instrument that is ubiquitous in developing countries: a minimum tax scheme whereby firms are taxed on either profits or turnover, depending on which tax liability is larger.
In Pakistan’s minimum tax scheme, the tax rate on profits (turnover minus costs) is equal to 35%, whereas the tax rate on turnover is 0.5% during most of the years we study. The scheme implies that firms for which the profit rate (profits divided by turnover) falls below the ratio of the two tax rates (0.5 divided by 35, which equals 1.43%) switch from the profit tax to the turnover tax.
We use the quasi-experimental variation generated by this threshold, combined with administrative tax records on all taxpaying corporations in Pakistan between 2006 and 2010, to estimate the extent to which a turnover tax reduces evasion.
The idea at the heart of our approach is as follows. The minimum tax threshold creates a discontinuity – a so-called ‘kink point’ – where firms switch between the profit and turnover tax regimes. At this kink point, both the tax rate and the tax base change discontinuously.
Turnover taxes provide a useful backstop for profit taxes in countries with widespread evasion
We argue that if it is easier to evade profit taxes than turnover taxes, then firms will have a strong incentive to locate at or around the kink. For example, consider a firm with a true profit rate of 3%. To evade taxes, the firm can over-report its costs so that its reported profit rate falls to about 1.4%. At this point, the firm will be required to pay taxes on turnover and any further exaggeration of its costs has no impact on its tax liability.
The firm could further reduce its tax liability by also under-reporting turnover, but hiding output may be more difficult than fabricating costs. In this case, the firm will settle for a reported profit rate of about 1.4%. Hence, with smaller evasion opportunities below the minimum tax threshold than above, we expect to see a disproportionate number of firms with profit rates close to the kink. In the jargon of economists, we expect to see ‘bunching’ of firms around the kink.
This is exactly what we observe when plotting the distribution of firms’ reported profit rates around the kink, as Figure 1 shows. Panel A of the figure shows the profit rate distribution for firms in 2006, 2007 and 2009, three years in which the turnover tax rate was equal to 0.5%. We see that a disproportionately large number of firms report a profit rate close to the kink point at 1.43%.
Figure 1: Profit rate distribution for taxpaying corporations in Pakistan
Panel A: High-rate firms in 2006, 2007 and 2009
Panel B: High-rate firms in 2010
Panel C: Low-rate firms in 2006, 2007 and 2009
Moreover, this bunching moves across time and across firms when the location of the kink changes, as Panels B and C show. In 2010, when the turnover tax increases to 1%, the kink moves to a profit rate of 2.86%. Similarly, recently incorporated firms are eligible for a reduced profit tax rate of 20%, moving the kink to a profit rate of 2.5%. In both cases, bunching in the profit rate distribution moves to the new location of the kink.
Estimating evasion responses
Bunching of taxpayers around thresholds where the tax rate jumps discontinuously has been used in recent studies to estimate behavioral responses to taxes – see Kleven (2016). Extending the methodology to our setting where both the tax rate and the tax base jump at the threshold, we use bunching at the minimum tax kink to estimate the evasion response to turnover taxation.
There are significant returns to increasing the tax enforcement capacity of developing countries
The sharp bunching around the kink must be driven by evasion rather than real output changes. While being taxed on turnover rather than profits might lead some firms to reduce real output, which could also generate bunching at the kink, this effect must be small due to the fact that the turnover tax is levied at a very low rate. Only the firms’ tax evasion behavior, combined with the differential ease of misreporting profits and turnover, can explain the large and sharp bunching.
Based on the empirical patterns in Figure 1, we estimate that the turnover tax in Pakistan reduces evasion by as much as 60-70% of corporate income compared with the profit tax. Hence, turnover taxes can provide a useful backstop for corporate profit taxes in countries with widespread evasion.
Our analysis allows us to rationalize the prevalence of production-inefficient policies in low- and middle-income countries. This highlights the dangers of relying on policy prescriptions derived from traditional public finance models, most of which were developed for high-income contexts.
Low-income countries should not rely on tax policy prescriptions developed for high-income contexts
Incorporating our empirical estimates in our theoretical model, we find that the optimal policy in a context like Pakistan is much closer to the production-inefficient turnover tax than the production-efficient profit tax. Indeed, switching from a pure profit tax to a pure turnover tax can increase revenue by up to 74% without reducing aggregate profits, thus creating substantial welfare gains.
The analysis takes the government’s ability to enforce taxes as given. But our large and striking results suggest there are potentially significant returns to increasing the tax enforcement capacity of developing countries.
However, the evolution of fiscal capacity tends to be slow-moving and depends on factors that are beyond direct policy control, such as the degree of self-employment, the structure of firms and the financial sector – see Gordon and Li (2009), Kleven (2014), Kleven et al (2016) and Jensen (2016). While fiscal capacity is still low, using alternative tax instruments such as turnover taxes can give governments the fiscal space to invest in public goods and develop their economies.
This article summarizes ‘Production vs Revenue Efficiency with Limited Tax Capacity: Theory and Evidence from Pakistan’ by Michael Best, Anne Brockmeyer, Henrik Kleven, Johannes Spinnewijn and Mazhar Waseem published in the Journal of Political Economy in 2015.