Periodic Reporting for period 4 - DEVTAXNET (Tax Evasion in Developing Countries. The Role of Firm Networks)
Reporting period: 2022-07-01 to 2022-12-31
Tax evasion presents an important challenge for public policy around the world. Building tax collection capacity is a foremost policy concern in developing countries because evasion levels are particularly high. For these countries, raising tax compliance is a fundamental necessity to be able to finance public infrastructure and social services while at the same time becoming less dependent on international aid. In addition to leading to billions of dollars in losses in government revenue, tax evasion can also lead to large distortions in the economy between activities that are taxed and activities that effectively escape taxation through evasion. However, due in part to severe data limitations, rigorous research on patterns of tax evasion and measures to reduce them has been quite limited. Taking advantage of unique datasets from Chile and Ecuador, this research studies key aspects of tax corporate tax evasion and avoidance. We combine these unique datasets with causal identification strategies to shed new light on policies aimed at increasing tax compliance and strategies firms use to circumvent such regulation. The goal is to generate insights that are of value not only for the tax authorities in Chile and Ecuador, but for researchers and policymakers in many other countries as well.
Sub-Project A: International Profit Shifting
This Sub-Project investigates the question of whether enforcing the OECD rules that currently govern the taxation of multinational firms with related subsidiary firms in several countries improve tax collection and welfare. This is one of the core debates in tax policy, with large implications for government revenue and inequality. Under current taxation regulations, subsidiaries of multinational firms are taxed separately in their respective locations, and are supposed to treat each other as if they were unrelated firms (the so-called “arm’s-length” principle). However, since these firms are in fact related through a common ownership structure, they face strong incentives to shift profits within the network of related firms into subsidiaries with low taxation, such that the subsidiaries in high-taxation countries have low profits and the network as a whole pays less taxes. To counteract such incentives, the OECD has been enacting a set of increasingly stringent norms that simultaneously require firms to report information about their international transactions and require tax authorities to monitor such transactions. In this project, we have published a journal article in the American Economic Association Papers & Proceedings that introduces the topic and the Chilean tax reform, and we have written a paper on the impact of the transfer pricing reform implemented in Chile in 2012. The paper is currently under review.
Sub-Project B: As noted in the second report, Subproject B has evolved in its focus since the original research design. The project addresses the large and widespread phenomenon of using so-called "ghost firms" (fake firms) that issue fraudulent receipts so that their clients, i.e. “ghost clients” can claim false deductions. While we cleaned and prepared the data to elaborate on the original research question, we saw interesting other patterns in the data that allowed us to investigate on the topic of ghost firms which we regarded to have more academic potential. Hence, the project focus shifted. We developed new empirical analyses in this reporting period and finished the writing process. We show that ghost transactions are widespread, prevalent among large firms and firms with high-income owners, and exhibit suspicious patterns compared to ordinary transactions: bunching at round numbers, at the end of the fiscal year, and just below financial system thresholds. Additionally, we studied an innovative enforcement intervention targeting ghost clients, rather than ghost firms themselves, which led to a substantial tax recovery. I presented the paper at several conferences and seminars, and, after implementing feedback, we have submitted it to a top-field journal and are awaiting a decision.
Sub-Project C: Foreign Direct Investment and Taxation
Similar to the process in Subproject B, the focus of the project evolved while working with the data at hand. While still using the same data as initially planned, we now studied the impact of international trade on earnings inequality. We developed new measures of export and import exposure at the individual level and provided estimates of their incidence across the earnings distribution. Thus, in this reporting period, we focused on implementing new empirical analyses and robustness checks, which were based on feedback received at conferences and seminars, as well as finishing the writing process and publishing a paper (see publications).
This Sub-Project investigates the question of whether enforcing the OECD rules that currently govern the taxation of multinational firms with related subsidiary firms in several countries improve tax collection and welfare. This is one of the core debates in tax policy, with large implications for government revenue and inequality. Under current taxation regulations, subsidiaries of multinational firms are taxed separately in their respective locations, and are supposed to treat each other as if they were unrelated firms (the so-called “arm’s-length” principle). However, since these firms are in fact related through a common ownership structure, they face strong incentives to shift profits within the network of related firms into subsidiaries with low taxation, such that the subsidiaries in high-taxation countries have low profits and the network as a whole pays less taxes. To counteract such incentives, the OECD has been enacting a set of increasingly stringent norms that simultaneously require firms to report information about their international transactions and require tax authorities to monitor such transactions. In this project, we have published a journal article in the American Economic Association Papers & Proceedings that introduces the topic and the Chilean tax reform, and we have written a paper on the impact of the transfer pricing reform implemented in Chile in 2012. The paper is currently under review.
Sub-Project B: As noted in the second report, Subproject B has evolved in its focus since the original research design. The project addresses the large and widespread phenomenon of using so-called "ghost firms" (fake firms) that issue fraudulent receipts so that their clients, i.e. “ghost clients” can claim false deductions. While we cleaned and prepared the data to elaborate on the original research question, we saw interesting other patterns in the data that allowed us to investigate on the topic of ghost firms which we regarded to have more academic potential. Hence, the project focus shifted. We developed new empirical analyses in this reporting period and finished the writing process. We show that ghost transactions are widespread, prevalent among large firms and firms with high-income owners, and exhibit suspicious patterns compared to ordinary transactions: bunching at round numbers, at the end of the fiscal year, and just below financial system thresholds. Additionally, we studied an innovative enforcement intervention targeting ghost clients, rather than ghost firms themselves, which led to a substantial tax recovery. I presented the paper at several conferences and seminars, and, after implementing feedback, we have submitted it to a top-field journal and are awaiting a decision.
Sub-Project C: Foreign Direct Investment and Taxation
Similar to the process in Subproject B, the focus of the project evolved while working with the data at hand. While still using the same data as initially planned, we now studied the impact of international trade on earnings inequality. We developed new measures of export and import exposure at the individual level and provided estimates of their incidence across the earnings distribution. Thus, in this reporting period, we focused on implementing new empirical analyses and robustness checks, which were based on feedback received at conferences and seminars, as well as finishing the writing process and publishing a paper (see publications).
It is widely suspected that some of the most common and difficult to detect forms of evasion involve interactions across firm networks. However, due to severe data limitations, the existing literature has mostly considered taxpayers as isolated units. Empirical evidence on tax compliance in firm networks is extremely sparse. This project aims to fill this gap by exploiting unique administrative datasets from Chile and Ecuador and novel applications of causal identification strategies. Through the three subprojects that we are undertaking, we expect to shed light on (i) the potential of increased information reporting requirement policies to address international profit shifting through transfer pricing, (ii) the nature, extent and fake firms, and (iii) the impact of international trade on earnings inequality.