Not(ch) Your Average Tax System: Corporate Taxation Under Weak Enforcement

Résumé

Boosting domestic tax collection is a major policy challenge for low and middle-income countries, however there remains considerable debate regarding the appropriate rate and breadth of the tax base. We use the unusual design of the corporate income tax in Costa Rica, administrative data on the universe of formal firms, and a novel methodology, which combines bunching at tax notches with a discontinuity approach, to estimate important parameters for the design of optimal tax policy. First, the elasticity of reported profits with respect to the tax rate is very large at roughly four. As a result the highest possible optimal tax rate is substantially lower than in rich economies. Second, we separate the profit elasticity into changes in declared revenue versus declared costs, and show that the cost elasticity is larger than the revenue elasticity. Firms’ apparent ease to understate profits by over-reporting costs rationalizes the use of broad tax bases with few deductions. Third, we provide evidence that tax evasion is a key driver, while real effects appear limited. Taken together, the data suggests that Costa Rican firms evade taxes on up to 75% of their profits when faced with a 30% tax rate, and that the revenue maximizing rate is between 18-26%. This implies that the optimal design of the corporate income tax in lower income countries could be substantially different from that of OECD countries.