Do Businesses Make Money By Overreporting On W-2

Profit vs. Revenue tax: How to brand corporations pay their fair share? Invitee mail by Thiago Scot.

| December x, 2020

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This is the 21st and concluding post in our series of posts by PhD students on the job market

"In life, 2 things are sure: decease and taxes, the saying goes. Unless you are a large multinational corporation, in which case, possibly not." This may sound similar political barrack to yous, simply it is not: information technology is a quote from the International Budgetary Fund (Imf). Multilateral institutions are heavily involved in improving tax enforcement: the World Bank recognizes that "mobilizing taxation acquirement is primal" for developing countries to finish farthermost poverty past 2030.

In my job marketplace paper, co-authored with Felipe Lobel (UC Berkeley) and Pedro Zúniga (Servicio de Administracion de Rentas), I partner with the taxation authority in Republic of honduras to study the impacts of a policy aimed at increasing tax collection from corporations: minimum taxes. Corporate income taxes are normally assessed on declared profits – gross revenue cyberspace of costs incurred in the production process. There is ample testify, however, that firms overreport their true costs to minimize their tax bills. Minimum taxes seek to assure that big firms will not avert revenue enhancement: in the case of Republic of honduras, firms declaring yearly revenue above L10 million (approximately USD 400,000) must pay the largest value between 25% of their declared profits and one.5% of their gross revenue. For these large firms (approximately the top 20% in terms of revenue), reporting low profits cannot reduce their tax neb.

While minimum taxes similar to this one are used across the world and recommended by the Imf, prove on their affect on tax collection and the behavior of firms is still scarce (Best, Brockmeyer, Kleven, Spinnewijn, & Waseem, 2015; Alejos, 2017; Mosberger, 2016). My paper contributes new evidence that can inform the design of these policies.

Under profit taxation, firms overreport costs to evade taxes

The immediate objective of the minimum revenue enhancement policy was to create a floor to how much taxes large corporations pay: regardless of declared profits, firms with revenue above L10 meg should pay no less than 1.five% of their declared gross revenues in taxes. That implies firms could no longer reduce their tax bill past overreporting costs and claiming low profits. In my get-go set of results, summarized in Effigy 1, I show that taxpayers reacted to the introduction of the minimum tax past substantially increasing their reported profits. In 2011-2013, earlier the minimum tax was in place, a big share of taxpayers alleged profit margins close to zero. When the incentives to overreport costs disappear in 2014, this behavior immediately changes: corporations outset reporting much higher profits, as seen by the shift of the profit margin distribution to the right. This is clear evidence that corporations were evading taxes through cost overreporting. I quantify this evasion response and estimate that under profit taxation firms were increasing claimed costs by as much equally 17% of profits in order to decrease taxes. This is similar to estimates from corporations in Islamic republic of pakistan, for example.

Corporate tax filings are complex documents and firms can claim over 100 different types of costs separately. One relevant policy question arising from these evasion responses is whether some cost items are particularly prone to evasion. I show that to be the instance: I observe no response in toll items that are hands traceable, such as labor and financial costs, but strong responses in difficult-to-verify items linked to costs of appurtenances and materials, like inventories. This suggests specific price items that tin can be the focal signal of government audits.

If y'all taxation revenues, taxpayers report less of it

My second prepare of results relates to how firms change their reported acquirement when facing higher taxes. Recall that firms declaring gross revenue below L10 million are exempt from the minimum revenue enhancement. This creates a threshold where tax liability might change discontinuously in response to small changes in alleged revenue. As an analogy, a firm declaring L9.99 1000000 in revenue and close to zero profits will pay almost no taxes (they are taxed on alleged profits) but declaring L10 meg would generate a tax liability of L150,000 (ane.five%*L10 1000000) under the minimum tax. This generates strong incentives for firms to strategically locate below the exemption threshold.

I show that firms do precisely that. We observe an excess number of firms declaring acquirement slightly below L10 meg while that was the exemption threshold. As shown in Figure two, those "bunchers" (taxpayers reducing revenue to avoid the minimum taxation) are non there earlier the introduction of the minimum taxation (2011 – 2013) nor later on the exemption level is substantially raised in 2018. I utilize tools from the bunching literature to quantify how alleged acquirement changes in face of changes in the tax charge per unit, i.e. to determine the elasticity of reported acquirement. I decide this elasticity to autumn in the range of [0.35, 1]. These estimates are meaningfully higher than previous findings in other contexts, such as Republic of costa rica. This illustrates the limits faced by tax authorities in increasing tax drove nether the existing enforcement environment: increasing tax rates leads to meaning decrease in the alleged taxation base of operations.

This decrease in reported revenue is partially explained past firms misreporting their earnings. I construct business firm-level measures of revenue observability, divers as the share of cocky-declared acquirement that is independently observed by the tax authority through third-party reporting. I testify that firms with high revenue observability are much less likely to strategically locate below the exemption threshold. I also testify that the same design holds across industries. In industries where revenue is more ofttimes independently assessed by the tax authority, such as manufacturing, nosotros see much less bunching below the exemption threshold and lower unsaid revenue elasticity. Having meliorate data on taxpayers' revenue seems to benumb their misreporting beliefs.

Policy implications

What should policymakers and citizens more than broadly take from our study? Outset, documenting widespread tax evasion is a first pace to garner political back up for policies that assure corporations pay their fair share – political date is key for enacting the right policies. Second, policymakers and multilateral organizations should recognize that the response of taxpayers to different policies is non immutable only depends on the enforcement surroundings. In the case of Honduras, improving third-party information on taxpayers' revenue would make the minimum tax more bonny since reported revenue would decrease by less. More broadly, our results are consistent with other contempo evidence that investments in the chapters of tax authorities might generate large gains in revenue by curbing evasion.

Thiago Scot is a PhD candidate at UC Berkeley Haas School of Concern