Research & Policy Briefs From the World Bank Malaysia Hub No. 45 April 2, 2021 Targeting Tax Enforcement Efforts on Larger Firms: A Necessary Distortion? Pierre Bachas To collect tax revenue and maximize the use of scarce enforcement capacity, some tax administrations focus their enforcement efforts disproportionately on large firms instead of enforcing taxes evenly on firms of all sizes: small, medium, or large. This Research & Policy Brief provides evidence that size-dependent tax enforcement is prevalent, especially in lower-income countries, leading to increasing effective tax rates as firms become larger. The Brief then quantifies the impact of this policy for aggregate economic production. It finds that the impacts are moderate (amounting to about a 1 percent decline in total factor productivity), and thus could be justified for tax authorities with limited resources, given documented tax revenue gains of stringent enforcement targeted to large firms. Finding the “Best” Option to Enforce Tax Collection in while allowing for redistribution. However, innate productivity the Face of Information and Capacity Constraints is unobservable to the government, which can only tax realized outcomes, such as the revenue and profits of a firm: this is the An ideal tax levies revenue to fund public goods while creating second-best tax system. In lower-income countries, the as few distortions as possible. The nondistortive first-best information and capacity constraints faced by tax corporate tax is a lump-sum tax that depends directly on firms’ administrations mean that even the second-best method might “innate” productivity. Such a tax would not distort production not be reachable because realized revenue and profits are hard Figure 1. The Relation between Tax Inspection and Firm Size by Industry in Six Major Developing and Emerging Countries Larger firms face much more scrutiny from tax inspectors in all six countries. a. Bangladesh b. Brazil c. China 100 100 100 Likelihood of tax inspection Likelihood of tax inspection Likelihood of tax inspection 80 80 80 60 60 60 40 40 40 20 20 20 0 0 0 0 20 40 60 80 0 20 40 60 80 0 20 40 60 80 Size rank Size rank Size rank d. India e. Indonesia f. Mexico 100 100 100 Likelihood of tax inspection Likelihood of tax inspection Likelihood of tax inspection 80 80 80 60 60 60 40 40 40 20 20 20 0 0 0 0 20 40 60 80 0 20 40 60 80 0 20 40 60 80 Size rank Size rank Size rank ISIC3 industry average Linear fit Source: Bachas, Fattal-Jaef, and Jensen 2019. Note: For each of the six most populous countries in the data set, this figure plots the probability of tax inspection in each ISIC3 industry by that industry’s average firm size (based on number of employees). The size of the circles corresponds to the total sales of that industry. ISIC = International Standard Industrial Classification of All Economic Activities. Affiliations: Development Research Group, World Bank. Acknowledgements: Norman Loayza provided valuable comments, insights, and suggestions. Excellent research assistance by Eva Davoine is gratefully acknowledged. Nancy Morrison provided excellent editorial assistance. Objective and disclaimer: Research & Policy Briefs synthesize existing research and data to shed light on a useful and interesting question for policy debate. Research & Policy Briefs carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions are entirely those of the authors. They do not necessarily represent the views of the World Bank Group, its Executive Directors, or the governments they represent. Targeting Tax Enforcement Efforts on Larger Firms: A Necessary Distortion? Figure 2. Impact of Tax Enforcement on Firm Size by Country Income Group Firm size has a much greater impact on tax enforcement in the lowest-income countries. .04 .03 Size-gradient in tax enforcement .02 .01 0 1 2 3 4 5 Development group (1=poorest, 5=richest) Source: Bachas, Fattal-Jaef, and Jensen 2019. Note: This figure shows the instrumental variables coefficients of regressions of tax enforcement on firm size. The development groups follow the World Bank income classification for 1 (low-income countries) to 4 (high-income countries), except for the highest-income group (GDP per capita exceeding US$21,000), which corresponds to the 90th percentile of income in the World Bank Enterprise Surveys and was chosen such that countries are comparable to the US in terms of economic development. to observe and not accurately self-reported. Thus, third-best Size-Dependent Tax Enforcement taxation becomes an option, whereby the government tries to balance administrative feasibility with the production Based on global evidence and analysis presented by Bachas, distortions that tax policies generate (Kleven, Khan, and Kaul Fattal-Jaef, and Jensen (2019), this Brief first provides evidence 2016). that larger firms face substantially more scrutiny from tax inspectors, and second, quantifies the impact of This Research & Policy Brief studies a specific third-best tax size-dependent tax enforcement on aggregate productivity. policy: segmenting corporate taxpayers by size and allocating a The relationship between size—as measured by a firm’s large share of resources to enforce taxes at the largest firms. To number of employees—and tax enforcement is shown with collect tax revenue, a constrained administration might focus microdata from the World Bank Enterprise Surveys covering its efforts disproportionately on larger firms instead of 140 countries. The surveys ask firms whether they were visited enforcing tax collection evenly across all firms. This is because by a tax inspector in the past year, and for an estimate of the large firms concentrate the tax revenue potential and generate share of sales that the typical firm in their sector reports when substantial third-party information trails (such as card filing taxes (as a way of detecting tax evasion). payments and client and supplier transactions), thus enabling tax inspectors to cross-check the self-reported values with The probability of tax inspection increases with average firm third-parties’ reports. Recognizing this, tax administrations size across industries, within each country, for a vast majority of increasingly target the largest firms (Kanbur and Keen 2014). countries in the sample, except for the highest-income ones. Indeed, between 1990 and 2010, more than 100 countries Figure 1 shows this relation for the six most populous countries adopted special enforcement units for large corporate in the sample. taxpayers (Bachas, Fattal-Jaef, and Jensen 2019). This size-dependent enforcement can generate distortions to firms’ The relation between size and tax inspection could be production and reduce their growth incentives: as firms biased due to strategic responses of firms to tax enforcement become larger their effective tax rate increases, which reduces policies: firms are aware that if they grow they would face more their after-tax profit margins. Thus, firms might stay too small stringent enforcement, and thus might decide to stay small. To compared to their optimal size and might underinvest. For the try to address this challenge, Bachas et al. (2019) relies on an economy as a whole, labor and capital might not be allocated exogenous measure of industry’s firm size, which should to the most productive firms. measure the optimal size of firms in an industry absent 2 Research & Policy Brief No.45 Figure 3. Aggregate Implications of Removing Size-Dependent Taxation Size-dependent tax enforcement has different types of impacts, but leads to moderate distortions overall. a. Total factor productivity b. Average firm size 1.008 1.3 1.004 1.1 1.000 0.9 1 2 3 4 5 1 2 3 4 5 Development group (1=poorest, 5=richest) Development group (1=poorest, 5=richest) c. Average innovation intensity d. Entry of firms 1.15 1.2 1.10 1.0 1.05 0.8 1.00 1 2 3 4 5 1 2 3 4 5 Development group (1=poorest, 5=richest) Development group (1=poorest, 5=richest) Source: Bachas, Fattal-Jaef, and Jensen 2019. Note: This figure shows the changes in aggregated total factor productivity, firm size, innovation intensity, and firm entry that would occur if size-dependent effective taxation was removed. Removing size-dependent taxation equalizes the probability of compliance at the level of the median-size firm, keeping fixed the revenue and profit tax rates. Each dot corresponds to a development group, following the World Bank classification for groups 1 to 4, where 1 refers to the low-income countries and 4 refers to the high-income countries. Group 5 corresponds to the richest countries in the sample with per capita income above US$ 21,000 to be most comparable with the US. strategic concerns. While no such perfect measure exists, the constraints, lowest-income countries rely more on authors use the average size of firms in industries in the US size-dependent enforcement. Thus, the differences in census. This instrument, akin to the approach in Rajan and enforcement and compliance between small and large firms Zingales (1998), is valid if the size of firms in the United States are larger for these countries. Figure 2 shows the slope of tax is not distorted by tax enforcement policy, and if the observed enforcement on firm size, for five groups of countries ranked by size in the data reflects firms’ optimal size. While this is income levels. The slope in the lowest-income countries is untestable, tax evasion levels are low in the United States double that of upper-middle income countries—and notably, (except among the self-employed) due to extensive third-party the slope in high-income countries is almost zero. information on firms of all sizes and the high enforcement capacity of the US federal tax authority, the Internal Revenue Impact on Production Distortions Service, thus making this assumption plausible. What does the size-dependence of firm-level tax enforcement Under this assumption, this brief measures the impact of imply for the aggregate economy? This Brief uses the lenses of firm size on tax enforcement. We find that this relation is a model of firm dynamics (Atkeson and Burstein 2010) to positive and statistically significant in countries around the quantify production distortions. In the model, firms of different world: a firm with an average of 50 workers compared to a firm productivities use labor to generate revenue and profits, which with 25 workers faces a 6 percentage points higher probability the government taxes at different effective tax rates depending of inspection (rising from 61 percent on average to 67 on firm size. Size-dependent taxation affects total factor percent). This translates to 5.5 percentage points more sales productivity (TFP) through three channels. First, it produces reported to the tax authority (from 81 percent on average to resource misallocation among exiting firms: large productive 86.5 percent). This relation varies as a function of countries’ firms that are taxed at a high rate employ too little labor income levels: as expected given information and administrative compared to the optimum, while smaller less productive firms 3 Targeting Tax Enforcement Efforts on Larger Firms: A Necessary Distortion? employ too much labor. Second, it distorts firms’ incentives to explain larger differences in TFP (Buera, Kaboski, and Shin invest because they know that by investing today, they will face 2011; Midrigan and Xu 2014). higher tax rates in the future once they have grown. Third, it alters the entry decision of new firms, as potential Policy Lessons entrepreneurs consider the rate they face once they create their (initially small) firm. The results show that size-based tax enforcement leads to a moderate reduction in total production: it depresses The Brief calibrates a representative economy for each investment and leads to resource misallocation, but is partially income group and evaluates the production gains in compensated by more firm creation. To assess whether equilibrium from reversing size-dependent taxation: instead of governments should use size-based tax policy, one needs to having tax enforcement increasing with firm size, the evaluate the potential gains in tax revenue. Basri et al. (2020) simulations fix the probability of inspection for all firms at the find that in Indonesia size-dependent taxation (through the level corresponding to the median-sized firm. Removing creation of regional offices directed to tax collection of medium size-dependent taxation yields a growth in TFP of 1 percent in and large sized firms) doubled the tax revenue collected. the lowest-income countries, where the size-gradient is the Similarly, Almunia and Lopez-Rodriguez (2017) show that in highest, and is neutral for the highest-income group, where the Spain extending the large taxpayer unit to encompass more compliance profile is already flat (figure 3). firms would collect much more revenue, while producing Thus, size-dependent tax enforcement leads to moderate limited distortions. The production distortions of distortions. This is due to the two counterbalancing size-dependent tax policies appear moderate in light of the mechanisms at play. Flat effective tax rates encourage firms to large tax revenue gains, and thus could be optimal for invest up to 10 percent more, since firms do not face higher tax constrained tax authorities. rates by growing. This distortion to investment is Going forward, technology promises to reduce the cost of counterbalanced by a decline in the entry of new firms into the tax enforcement and could provide a path for governments to economy: the entry rate falls by 20 percent because new enforce taxes more evenly across the firm size distribution entrants (small firms) now face a higher average tax rate (that while keeping administrative resources constant (IMF 2017). of the median firm under size-dependent enforcement) than Technology could alleviate size-dependent taxation in poor the one they had initially. The higher investment of existing countries and produce additional positive impacts for firms, combined with the lower entry rate of firms, imply that productivity and tax revenue collection: a wider tax net could the average firm size increase by over 30 percent in the reduce the unfair competition that formal firms face from the lowest-income countries when size-dependent taxation is informal sector (Ulyssea 2018) and generate more extensive removed. third-party information trails (Pomeranz 2015), thus making The simulations yield predictions that are consistent with enforcement efforts more efficient. However, new technologies the evidence on cross-country differences in the average firm are not a panacea; they require careful implementation and size (Bento and Restuccia 2017) and life-cycle growth of firms training for tax inspectors to use them. In addition, low (Hsieh and Klenow 2014). Yet the production distortions from effective taxation of small firms has benefits. As discussed in size-dependent enforcement of 1 percent are moderate and this Brief, it encourages small firms to enter the formal sector; can only explain a small share of the total factor productivity it can also introduce progressivity to the tax system by de facto gap between high-income and low-income countries (Hsieh exempting goods and services consumed disproportionately by and Klenow 2009). The results are, however, in line with other the poor (Bachas, Gadenne, and Jenson 2020). Hence, the studies that consider a single distortion such as labor laws adoption of technology that enables more even tax (Gourio and Roys 2014; Garicano, LeLarge, and Van Reenen enforcement could be combined with de jure policy tools such 2016), with the exception of financial frictions, which can as simplified tax regimes for small and new firms. References Almunia, M., and D. Lopez-Rodriguez. 2018. "Heterogeneous Responses to Effective Tax Enforcement: Hsieh, C.-T., and P. Klenow. 2009. "Misallocation and Manufacturing TFP in China and India." Quarterly Evidence from Spanish Firms." American Economic Journal: Economic Policy. 10(1): 1-38. Journal of Economics 124 (4): 1403–48. Atkeson, A., and A. T. Burstein. 2010. "Innovation, Firm Dynamics, and International Trade." Journal of ---------. 2014. "The Life Cycle of Plants in India and Mexico." Quaterly Journal of Economics 129 (3): Political Economy 118 (3): 433–84. 1035–84. Bachas, P., R. Fattal-Jaef, and A. Jensen. 2019. "Size-Dependent Tax Enforcement and Compliance: Global IMF (International Monetary Fund). 2017. Digital Revolutions in Public Finance. Washington, DC: Evidence and Aggregate Implications." Journal of Development Economics 140: 203–22. International Monetary Fund. Bachas, P., L. Gadenne, and A. Jensen. 2020. "Informality, Consumption Taxes and Redistribution." NBER Kanbur, R., and M. Keen. 2014. "Thresholds, Informality, and Partitions of Compliance." International Tax Working Paper 27429, National Bureau of Economic Research, Cambridge, MA. and Public Finance 21 (4): 536–59. Basri, M. C., M. Felix, R. Hanna, and B. A. Olken. 2020. "Tax Administration vs. Tax Rates: Evidence from Kleven, H., A. Khan, and U. Kaul. 2016. "Taxing to Develop: When ‘Third-Best’ Is Best." IGC Growth Brief Corporate Taxation in Indonesia." NBER Working Paper 26150, National Bureau of Economic Research, Series 005, International Growth Centre, London School of Economics and Political Science. Cambridge, MA Bento, P., and D. Restuccia. 2017. "Misallocation, Establishment Size, and Productivity." American Midrigan, V., and D. Y. Xu. 2014. "Finance and Misallocation: Evidence from Plant-Level Data." American Econonmics Journal Macroeconomics 9 (3): 267–303. Economic Review 104 (2): 422–58. Buera, F. J., J. P. Kaboski, and Y. Shin. 2011. "Finance and Development: A Tale of Two Sectors." American Pomeranz, D. 2015. "No Taxation without Information: Deterrence and Self-Enforcement in the Value Added Economic Review 101 (5): 1964–2002. Tax." American Economic Review 105 (8): 2539–69. Garicano, L., C. LeLarge, and J. Van Reenen. 2016. "Firm Size Distortions and the Productivity Distribution: Rajan, R. G., and L. Zingales. 1998. "Financial Dependence and Growth." American Economic Review 88 (3): Evidence from France." American Economic Review 106 (11): 3439–79. 559–86. Gourio, F., and N. Roys. 2014. "Size-Dependent Regulations, Firm Size Distribution and Reallocation." Ulyssea, G. 2018. "Firms, Informality, and Development: Theory and Evidence from Brazil." American Quantitative Economics 5 (2): 377–416. Economic Review 108 (8): 2015–47. 4