Abstract

How should developing countries tax corporate income? This paper studies this question in Costa Rica, where firms face discontinuously higher average tax rates on profits when their revenue marginally increases. The paper combines a discontinuity and a bunching design to estimate the profit elasticity and separate it into revenue and cost elasticities. Faced with higher tax rates, firms slightly reduce revenue but considerably increase costs, generating a large elasticity of profits. In this context, the revenue maximizing rate for profit taxation is below 25 percent and broadening the tax base while lowering the rate can increase revenue for these firms by 80 percent.

Highlights

  • Lower-income countries only collect 20% of their GDP in taxes, compared to 35% on average for OECD countries (Gordon and Li 2009, Besley and Persson 2013)

  • Brockmeyer, Kleven, Spinnewijn and Waseem (2015) model this revenue versus production efficiency trade-off and empirically find that a broader corporate tax base is desirable in Pakistan

  • A falling profit elasticity with size provides a plausible rationale for tax systems with average tax rates as a function of revenue: such systems tag firms based on revenue, which we find is hard to adjust, and apply increasing tax rates satisfying an inverse elasticity rule

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Summary

Introduction

Lower-income countries only collect 20% of their GDP in taxes, compared to 35% on average for OECD countries (Gordon and Li 2009, Besley and Persson 2013). Since the corporate tax typically allows for all production costs to be deducted, firms could reduce their tax base by over-reporting costs (Slemrod, Collins, Hoopes, Reck and Sebastiani 2015, Carrillo, Pomeranz and Singhal 2017). Some countries address this challenge by applying a lower rate to a broader base, with limited deductions, thereby reducing evasion incentives. Brockmeyer, Kleven, Spinnewijn and Waseem (2015) model this revenue versus production efficiency trade-off and empirically find that a broader corporate tax base is desirable in Pakistan Their variation mixes firms’ revenue and profits responses, which prevents them from separately estimating these key elasticities. The elasticity of profits is required to measure the revenue maximizing rate under a profit tax, and both the revenue and profit elasticities are needed to jointly estimate the optimal rate and base

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