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Tax Evasion in Developing Countries. The Role of Firm Networks

Periodic Reporting for period 2 - DEVTAXNET (Tax Evasion in Developing Countries. The Role of Firm Networks)

Reporting period: 2019-07-01 to 2020-12-31

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 in order 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 in order 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 completed a first draft of the article that presents the results of the impact evaluation study.

Sub-Project B: Intranational Profit Shifting
One area of tax evasion and avoidance that has not been studied previously so far is intranational profit shifting among firms within a conglomerate of joint ownership structure. Such profit shifting has the goal of minimizing tax payments at the conglomerate level, similar to the case of multinational firms that try to shift profits across their network of subsidiaries. Detecting this type of intranational collusion is particularly challenging, as it requires access to data not only on firms’ tax payments, but also on two key additional sources of information: (i) the ownership structures and relations between firms, and (ii) the transactions between firms that are used to shift profits to other parts of the network. In this project, we are able to study this thanks to unique administrative tax records, combined with exogenous shocks to the profitability of certain firms within the network. Intranational profit shifting can involve similar schemes as those employed in international profit shifting—such as charges of bogus consulting or marketing services by related firms, or input mispricing—which shift profit from otherwise profitable firms to related non-profitable firms. They sometimes also involve non-profit entities, which launder profits of firms and declare them as activities of the charitable association. This type of cross-ownership collusion is anecdotally thought to be widespread in many countries, but there is little rigorous evidence on this. In this project, the research team has made substantial progress in assembling, cleaning and processing the datasets for analysis.
Sub-Project C: Foreign Direct Investment and Taxation

In many countries, it is common to encounter passionate disagreement about the arrival of foreign-owned firms operating on domestic soil. These foreign multinational firms may bring technical expertise, new products, and increased demand for domestically-sourced inputs and factors of production. But many commentators have been wary of some of the negative impacts that new foreign entrants can have, particularly if they displace incumbent domestic firms through enhanced competition and repatriate profits to their home country. Against this backdrop, a key policy question concerns whether governments should subsidize (or penalize) the entry of foreign firms. Analytically, traditional thinking suggests that government intervention is justified only when foreign firms impose externalities on the domestic economy. A large empirical literature has attempted to estimate some of these externalities—the so-called spillovers from foreign direct investment (FDI)—yet credible estimates of these phenomena have been hard to come by. In order to analyze this issue, I combine information on FDI with unique transaction-level data to identify which are the suppliers and client firms of firms receiving FDI. In order to causally identify the impact of FDI, I will employ an event study design to compare trading partners of treated firms (firms receiving FDI) to trading partners of control firms, who do not receive FDI, but are similar to treated firms along observable characteristics. In this project, we have collected the administrative datasets and started preliminary analysis work.
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 costs of intranational tax collusion and profit shifting, and (iii) the interaction between international and national firm dynamics and how this influences tax and other firm behaviours.