Tax Structures in Developing Countries: Many Puzzles and a Possible Explanation. Roger Gordon and Wei Li * UCSD and University of Virginia

Transcription

1 Tax Structure n Developng Countre: Many Puzzle and a Poble Explanaton by Roger Gordon and We L UCSD and Unverty of Vrgna March, 005 Abtract: Tax polce een n developng countre are puzzlng on many dmenon. To begn wth, revenue/gdp urprngly mall compared wth that n developed econome. Taxe on labor ncome play a mnor role. Taxe on conumpton are mportant, but effectve tax rate vary dramatcally by frm, wth many frm avodng taxe entrely by operatng through cah n the nformal economy and other facng very hgh lablte. Taxe on captal are an mportant ource of revenue, a are tarff and egnorage, all contrary to the theoretcal lterature. In th paper, we argue that all of thee apect of polcy may be enble repone f a government able n practce to collect taxe only from thoe frm that make ue of the fnancal ector. Through ue of the fnancal ector, frm generate a paper tral, facltatng tax enforcement. The threat of dntermedaton then lmt how much can be collected n taxe. Taxe can mot ealy be collected from the frm mot dependent on the fnancal ector, preumably captal-ntenve frm. Gven the reultng dfferental tax rate by ector, other polce would enbly be ued to offet thee tax dtorton. Tarff protecton for captal-ntenve frm one. Inflaton, mpong a tax on the cah economy another. eyword: tax polcy n developng countre, nformal economy, nflaton, tarff, red tape, captal taxe, corrupton JEL code: H,O3, O7, F3,F3 We would very much lke to thank partcpant at emnar at Harvard, MIT, the Boton Fed, NBER, the IMF, Berkeley, Mchgan Law School, and partcularly Sören Bo Nelen for helpful comment on an earler draft. We would alo lke to thank the World Bank for fnancal upport for th proect.

2 The pat academc lterature on tax polcy ha focued almot entrely on the analy of tax tructure n the rchet countre, partcularly the U.S. Overall the optmal tax model explan reaonably well the oberved tax polce n thee countre. A ummarzed n Gordon (000), for example, pat theoretcal work ugget that taxe on conumpton or labor ncome hould domnate ue of captal ncome taxe n open econome under plauble aumpton. Content wth th, value-added taxe, peronal ncome taxaton of labor ncome, and payroll taxe are the mot mportant ource of revenue n many countre. Even under the ncome tax, a large fracton of peronal avng n practce tax exempt. Of coure there are ome devaton between the forecat from model of optmal polcy and oberved government polce even n the rchet countre. For example, Fredman (969) argued that the optmal nflaton rate hould be negatve (to brng nomnal nteret rate down to zero), wherea oberved nflaton rate have been potve even f relatvely low. Optmal tarff hould be cloe to zero, gven that countre rarely have much market power n partcular commodte beyond what ndvdual frm have. Tarff n the pat have been large, but wth GATT and now the WTO, tarff at leat among developed countre are ndeed very low. Tax polce n developng countre are much more puzzlng, however. Thee dfference are lad out n more detal n ecton. To begn wth, poorer countre collect on average only two-thrd or le of the amount of tax revenue that rcher countre do, a a fracton of GDP. Yet, gven the evere need for nvetment n ay nfratructure and educaton n thee countre, t plauble that the lack of revenue mply repreent dfferng tate for publc v. prvate good n poor v. rch countre? Whle the peronal ncome tax the domnant ource of tax revenue among rcher The larget nvetment for mot people are ther houe, conumer durable, and penon. The return on thee form of avng largely exempt from tax n mot countre. Gordon, alambokd, and Slemrod (004ab) report evdence that the U.S. collect lttle or no net revenue from taxe on captal ncome, and mpoe much lower dtorton on nvetment and avng decon than t at frt appear gven the tatute. Feldten (997) calculated a large effcency gan from lowerng the nflaton rate toward zero, even from a lo w potve ntal level, due to the lack of correcton for nflaton n the meaurement of taxable ncome.

3 countre, t only a mnor ource of revenue among the pooret countre. Intead, the corporate ncome tax a much more mportant ource of tax revenue, a are tarff and egnorage. Yet the extng optmal tax theore argue that tarff and egnorage are partcularly poor ource of tax revenue, whle dtorton to nvetment ncentve created by a corporate tax hould alo be avoded. A natural tartng pont n explanng thee dfference n tax polcy greater tax enforcement problem n poorer countre. One mportant ue largely neglected n extng optmal tax model the effect of the tax tructure on the ze of the nformal (underground) economy. Accordng to the etmate reported n Schneder and Ente (000), the nformal economy on average only about 5% of GDP among OECD countre, o mall enough that t hould not be a drvng factor n the choce of tax tructure. However, among developng countre, the medan ze of the nformal economy they report 37% of GDP, rangng from 3% n Hong ong and Sngapore to 7% n Thaland and 76% n Ngera. The huge varaton n the ze of the nformal ector acro countre ugget that any effect of the tax tructure, or of government polce more generally, on the ze of the nformal ector can be of frt-order mportance n the choce of thee polce. Yet at th pont, we know relatvely lttle about how polce affect the ze of the nformal ector. The obectve of th paper to explore the mplcaton of a pecfc hypothe about the factor affectng the choce of a frm whether to be part of the formal or the nformal economy. We how that addng th hypothe to an otherwe tandard optmal tax model can ealy explan each of the above dfference n polce between poor and rch countre, along wth a varety of other dfference n oberved polce. The key aumpton n the paper that frm can avod tax payment n any country by hftng entrely to cah tranacton and not ung the fnancal ector, thereby avodng 3

4 leavng any paper tral. 3 When frm make ue of the fnancal ector, n contrat, the government can gan acce to ther bank record and ue th nformaton n enforcng the tax law. 4 Frm then have to chooe whether the economc beneft from ue of the fnancal ector are greater or le than the reultng tax lablte. Poorer countre dffer from rcher countre under our hypothe mply becaue the value frm receve from ung the fnancal ector much more modet. When the value from ung the fnancal ector low, the government need to worry about poble dntermedaton and the reultng lo of t tax bae when choong t tax tructure. Th threat of dntermedaton not only can keep tax rate low, but can alo have mportant effect on the degn of the tax tructure, and on government polce more generally. We preume, for example, that captal-ntenve frm are more dependent on the fnancal ector, allowng the government to mpoe hgher taxe on them wthout nducng dntermedaton. In poorer countre, taxe do eem to be pad far more heavly by captal-ntenve frm than by the ret of the economy. Relyng more heavly on corporate ncome taxe one mean of focung tax collecton on the frm that are mot dependent on the fnancal ector. Wth the reultng much hgher effectve tax rate on captal-ntenve frm, one would expect to ee fewer captal-ntenve frm. Th not at all apparent gven the data, uggetng that there are polce n place to protect thee frm, and thereby protect the government tax bae. An example would be tarff protecton for ndutre domnated by captal-ntenve frm. Another polcy that mplctly favor thee frm nflaton. Frm that ue the fnancal ector are largely protected from nflaton, wherea thoe frm that rely on cah tranacton o a to evade tax are thereby vulnerable to nflaton. 3 Cah tranacton are extremely hard to montor even n the rchet countre. Lkely for th reaon, llegal actvty eem to rely heavly on cah tranacton. 4 Among the rchet countre, government rely on frm to provde nformaton about ndvdual wage and dvdend ncome, and then on accountng report and tax audt both to double-check thee report by frm on ndvdual earnng and to document each frm own earnng. Accountng frm and tax audt, n turn, rely heavly on the record of a frm tranacton through the fnancal ector, makng thee record a key underlyng ource of nformaton upportng mot form of taxe. 4

5 Polce may enbly encourage or hnder nvetment by multnatonal, dependng on the government ablty to tax multnatonal v. competng dometc frm. There may even be an effcency gan from ntroducng red tape hnderng actvty n the untaxed ector. Of coure, polce hnderng entry of new frm may n the proce harm economc growth, a argued by Schumpeter (94). Wthout protectng t tax bae, however, a government may not be able to afford bac government ervce n the preent. A the fnancal ector mprove n effectvene, more frm wll be pulled nto ung t n pte of the tax mplcaton of dong o. Wth a broader and le elatc tax bae, tax polcy can hft toward the type of polce eem n developed countre, and recommended by the tradtonal optmal tax lterature. Wth a broader tax bae, there le need for polce hnderng entry and growth of new frm. Our paper therefore provde an addtonal ratonale for the emprcal evdence urveyed n Levne (004) lnkng mprovement n the fnancal ector and economc growth. It n fact ugget that mprovement n the fnancal ector may be a prerequte for fundamental tax reform. Secton develop the bac model for the choce of tax tructure, gven the threat of dntermedaton. Secton 3 explore a varety of upplementary polce a government can ue to protect t tax bae. Secton 4 then provde a bref dcuon of a related puzzle why tate-owned bank are o common among poorer countre. What compenate for the preumed reultng effcency lo from publc ownerhp? Snce the government need to rely on bank to gather nformaton about frm, t need ome control to aure acce to th nformaton. Drect ownerhp one approach. In addton, drect ownerhp may be valuable n order to dcourage lendng to untaxed frm, and perhap to nduce lendng to taxed frm even when the bank loe money, gven the gan to the government from the reultng tax revenue on the new nvetment. 5

6 Fnally, ecton 5 provde a bref ummary and dcuon.. Data on tax polce n poor v. rch countre Table compare the ource of tax revenue among countre of dfferent ncome level. To begn wth, a een n the Table, the pooret countre collect two-thrd or le of the revenue collected n the rcher countre, a a fracton of GDP. Among the rchet countre, the man ource of revenue are the peronal ncome tax (4.7% = 54.3%(-.78) of revenue) and varou type of conumpton taxe (3.9% of revenue). Conumpton taxe are even more mportant among the pooret countre (5.% of ther lower tax revenue), but the peronal ncome tax of mnor mportance, collectng only 4.3% of tax revenue. Intead, the corporate ncome tax much more mportant (9.3% of revenue, compared wth 9.7% n rcher countre), and tarff are alo mportant (6.4% of revenue, compared wth a trval fracton n rcher countre). A een n the Table, egnorage repreent a maor nontax ource of revenue among the pooret countre (.5% of tax revenue, compared wth.0% n rcher countre). A a reult, nflaton rate among the pooret countre on average tend to be much hgher. Thee harp dfference n ource of tax revenue do not eem to correpond to harp dfference n tatutory tax rate between poor and rch countre, however. Among a lmted et of countre where we have been able to acqure data, lted n Table, the average maxmum tatutory tax rate under the VAT are very cloe among poor v. rch countre (4.7% v. 6.%). The average maxmum corporate tax rate are alo very cloe (6.7% v. 9.6%), whle the maxmum peronal tax rate are not that dfferent (34.7% v. 4.8%). The effectve tax rate, though, mut be very dfferent gven the lower fracton of GDP collected by thee taxe among poorer countre, preumably due to ther much larger nformal econome. A een n Table, etmate of the ze of the nformal economy 6

7 are on average more than twce a large n poorer countre than n rcher countre. A a mple ummary decrpton of how tax revenue relate to thee tax rate, we regreed (tax revenue)/gdp agant the maxmum VAT rate and the mnmum of the top peronal and corporate tax rate, 5 focung eparately on data from poorer and rcher countre. If countre are otherwe the ame, but mply dffer n ther tax rate, then the coeffcent on each tax rate hould equal the ze of the tax bae, a a fracton of GDP, multpled by the rato of the average to the maxmum tax rate. Ung data from the rcher countre (8 obervaton), reult eem qute enble: Revenue/GDP = mn(t,t).58, R =0.4 (.07) (.0) (.9) Here, t the maxmum peronal tax rate, t the maxmum corporate tax rate, whle the maxmum conumpton tax rate. Conder, for example, the coeffcent of.58 on. If the conumpton tax bae on average were roughly /3 of GDP, then the mpled effectve tax rate (.58/.67) =.87. Gven the common ue of lower tax rate on ervce and necete uch a food, th etmate eem qute reaonable. The coeffcent of.46 on the mnmum ncome tax rate alo eem plauble, gven the frequent ue of a progreve rate tructure under the peronal ncome tax, leadng to an average tax rate much below the maxmum tatutory rate. Wth data from poor countre (5 obervaton), n contrat, reult are dramatcally dfferent: Revenue/GDP =. -.3 mn(t,t)., R =0.38 (.03) (.07) (.09) 5 Our motvaton for focung on the mnmum of the peronal and corporate ncome tax rate the apparent eae of hftng ncome between the corporate and peronal tax bae, a documented for example n Gordon and Slemrod (000). If th ncome hftng uffcently cotle, then only the mnmum rate matter. When we add the maxmum tax rate, t ha a tny and ngnfcant coeffcent. When we nclude both corporate and peronal tax rate eparately, the qualtatve reult are the ame, but the ft not a good. 7

8 One poble explanaton for the lower coeffcent on that the average VAT rate much below the maxmum tatutory tax rate, perhap becaue the underground economy often very large n poorer countre. The negatve coeffcent on the ncome tax rate, however, ugget revere cauaton: when revenue very low due to a large underground economy, tatutory tax rate become hgher to collect more from the few frm that reman part of the taxed ector. Thee are certanly the nterpretaton we wll ugget baed on the theory decrbed next.. Tax polcy when nformaton lmted Optmal Sale Tax Rate Extng model dervng optmal tax polcy typcally aume that the government can oberve the ncome earned by all factor and by all frm, even f underlyng ablty not obervable. How do forecat for the optmal tax polcy change f the extence of an nformal economy able to evade tax taken nto account explctly? Conder the followng hghly tylzed ettng. The economy cont of a collecton of ndutre. Frm n ndutry have a Cobb-Dougla producton functon f b b L, where f denote ndutry output, denote the ndutry captal tock, and L t labor nput. There free entry to each ndutry, o that each frm earn zero net-of-tax proft n equlbrum. If a frm doe not make ue of the fnancal ector, 6 ung cah for all tranacton, t leave no paper tral. A a reult, we aume that the government doe not oberve anythng about the frm, ncludng t extence, o cannot mpoe any taxe on t. 6 We mplfy the analy by aumng that frm n an ndutry ue bank for ether all or none of ther tranacton. 8

9 Proft for uch a frm then equal p f r wl, where p the output prce n ndutry, et on the world market, 7 r the local nteret rate, and w the local wage rate. If a frm n ndutry doe ue a fnancal ntermedary, dong o ncreae t output by the fracton a, 8 o that output become ( a ) f, and pretax proft become ( a ) p f r wl. If frm n the ndutry do chooe to ue bank, then the government can oberve all t tranacton through audtng the bank record. It can then mpoe taxe baed on th nformaton. Conder frt the optmal ue of ale taxe at rate on each ndutry. If the ale tax collected whether output old abroad or on the dometc market, a we aume, then ( ) p = p, where p the prce dometc frm now receve, net of the ale tax payment. The reultng tax revenue equal p f T = p f, T where = /( ) and where T decrbe the et of ndutre that make ue of bank, o are taxable. If all frm ue bank, then we are back to the tandard framework n whch the government can oberve and tax all ale. Let β = f the frm n ndutry ue bank, wth β = 0 otherwe. Gven thee aumpton, each frm act to maxmze expected net-of-tax proft, o chooe factor nput and β baed on: 7 We aume the country mall, o a prce taker n world market. Whle we allow for free trade n good, we aume no captal flow and for the moment no foregn drect nvetment. 8 In prncple, a can be negatve. Th could occur when frm fear that the bank wll abcond wth ther fund, or at leat lmt ther ablty to wthdraw cah when needed. 9

10 max β (( β ) p f p ( )( a ) f r wl ), L, β Frm that ue bank chooe captal nput o that p f / = r/[( )( a )], whle p f / = r otherwe, wth comparable equaton determnng labor nput. Frm wll chooe to ue bank f and only f dong o rae ther net proft, o f and only f ( a )( ) >, n whch cae () a < a. Put mply, frm ue bank when the economc gan from ue of the fnancal ector outwegh the reultng lo from beng ubect to the ale tax, even gven that thee economc gan are themelve ubect to the ale tax. If the ale tax rate n ndutry volate th nequalty, then t would nduce dntermedaton n th ndutry, and collect no revenue. Equaton () then repreent an mplct contrant that optmal ale tax rate hould atfy. If the tax rate n any ndutry raed hgh enough to nduce dntermedaton, then there a dcrete drop n tax revenue from that ndutry wth no reultng gan to frm n the ndutry, o a Pareto lo. Thee contrant are the key addtonal feature characterzng optmal tax rate once the poblty of dntermedaton and the reultng tax evaon taken nto account. Thee contrant have mmedate mplcaton for the varaton of ale tax rate wthn a country, and alo for varaton n average ale tax rate acro countre. Regardng the latter, countre n whch the a are ytematcally larger, o n whch the fnancal ector provde greater value-added to frm, can feably mpoe hgher ale tax rate wthout nducng dntermedaton and a lo of t tax bae. Whle the nequalty 0

11 condton n equaton () hould ealy be atfed n rcher countre, o have no effect on tax polcy, we hypotheze that thee condton are a key factor lmtng feable tax rate and the amount of tax revenue that can be collected n poorer countre. If tax rate have been raed to ther maxmum feable level, then a country wll be unable to rae further revenue regardle of the ocal value of addtonal government expendture. The key determnant of government revenue then mply the a. If tax rate can dffer by ndutry, then rate would be choen o that all ndutre make ue of bank, o reman part of the tax bae. Feable ale tax rate vary by ndutry baed on equaton (), o depend on the value of an ncreang functon of a n each ndutry. We aume that b, the weght on captal n the producton functon. Mantanng account wth a bank allow the bank to montor the frm performance, gvng the bank nformaton about the frm a well a potental collateral. Both facltate future lendng to the frm, gvng the frm acce (or at leat cheaper acce) to outde fnancng. Loan are relatvely more valuable to a frm the greater the amount of captal t need to fnance. Frm wth a hgher value of b, by demandng a hgher captal/labor rato, therefore gan more from ue of bank. Ue of bank alo preumably more valuable the greater the phycal dtance at whch a frm engage n market tranacton, nce bank are degned to facltate fnancal tranacton at a dtance. For mplcty, we aume that more captal-ntenve frm are alo thoe frm more lkely to trade at a dtance, perhap becaue the mnmum effcent ze of a frm larger the greater t captal ntenty. Alo, nce captal-ntenve frm have greater ale revenue per employee, captal-ntenve frm wll be more concerned about allowng cah tranacton, gven the threat of nternal theft by employee, leadng to a preference to have tranacton flow ntead through the fnancal ector. a The feable tax rate, a a fracton of factor ncome, are then hgher for captal-ntenve ndutre, whch have a hgher value of a. Even f a unform ale tax rate would be optmal gnorng the contrant n equaton (), tax rate need to be reduced for le

12 captal-ntenve ndutre when equaton () become bndng, and then perhap raed for more captal-ntenve ndutre to compenate for the reultng lo n tax revenue. Indutre, a defned n practce under the tax law, are nevtably heterogeneou, however. Any ncreae n a ale tax rate for a broad group of ndutre wll then caue ome dntermedaton, addng a new ource of exce burden beyond thoe commonly condered. The more elatc the extent of dntermedaton at the margn, the hgher the margnal exce burden from a rate ncreae, everythng ele equal. The global optmum could n theory nvolve very hgh tax rate wth a very narrow tax bae, dependng on parameter. For example, f one et of frm would alway ue the bankng ytem, then a very hgh n prncple can collect ubtantal revenue from thee frm at the cot of collectng lttle or nothng from other frm. Lowerng the tax rate by enough to pull more frm nto the tax bae may lower overall tax revenue too much to be attractve. Optmal tax rate can be very hgh, n pte of the threat of dntermedaton. Optmal Ue of Captal Taxe Captal taxe can help collect addtonal revenue whle leavng unchanged or reducng the degree of dntermedaton. To ee th, tart from the above ettng wth potve ale tax rate n all ndutre. Wthn a gven ndutry wth heterogeneou frm, for any gven ntal ale tax rate, there hould be ome b at whch a frm ut ndfferent to ung bank. Any frm k n th ndutry wth b k > b wll ue bank, and converely. 9 Conder ntroducng a margnal tax rate, t, on captal, wth a compenatng margnal cut n ut uffcent to leave net proft unchanged for frm wth b = b. Gven the Cobb-Dougla aumpton, th mple that 9 Frm wth b k < b then contnue to evade taxe.

13 / t = b ( ). Wth thee combned tax change, frm wth b = b by contructon reman ndfferent to ung bank. Startng from a ettng wth t = 0, tax revenue from frm wth b = b alo unchanged. Tax payment by any frm k wth b k > b go up, however, due to thee combned tax change. Startng from t = 0, the margnal change n tax payment equal r k p ( a )[ f k t f t k ] = p ( a )[( b k b )( ) f k f t k ], gven that r = b ( ) p ( a ) f wth a Cobb-Dougla producton functon. k k k Snce by contructon b k > b, the frt term potve. Th outwegh the econd term a long a the effectve tax rate on frm k below the rate at the top of the Laffer curve. 0 Intutvely, nce thee other frm are more captal ntenve, the cut n the ale tax rate not uffcent to offet the ncreae n the tax on captal expendture. Th margnal tax change wll not nduce any dntermedaton, nce thee frm dcretely ganed from ue of bank. There no margnal exce burden from dtorton to captal/labor rato, nce the tax change mpoed at a pont where th choce effcent. Introducng a mall tax on captal ncome therefore rae more revenue whle leavng unchanged the extent of dntermedaton. Further ncreae n t n prncple could eventually nduce dntermedaton among ome of the more captal-ntenve frm wthn the ndutry. To udge when th mght occur, let r r( t ) /[( a )( )] and w = w/[( a )( )] repreent the effectve factor prce. Then wth a Cobb-Dougla producton functon, the unt cot equal b ( b) b b b ( b) ( r ) ( w ). Ung bank contnue to be attractve for any frm wth b > b f and only f 0 Throughout, we aume that the tax rate reman below the rate at the peak of the Laffer curve. 3

14 ( a ( t ) b ( b))( ) < for all b > b, gven that by defnton th equaton ut atfed for frm wth b = b. Th condton equvalent to the condton () holdng for all b > b. a ( b) ( b b ) > ( t ) a ( b ) If equaton () hold n all ndutre, then tax revenue contnue to ncreae a t ncreae, wth compenatng cut n each of the to avod any reultng dntermedaton. Preumably, however, each of the mut reman nonnegatve. Increae n t can then be offet by compenatng cut n the to prevent any dntermedaton only for ndutre that tll have > 0. Further ncreae would tll rae addtonal revenue n the ndutre that have > 0, but loe revenue from frm n ndutre wth = 0that leave the tax bae due to the re n b. Our forecat that captal tax rate wll be ued heavly harply contrary to the forecat from the tandard model that captal ncome taxe wll play lttle or no role n an optmal tax ytem, though th forecat broadly content wth the oberved heavy ue of corporate ncome taxe and lmted ue of labor ncome taxe among the pooret countre. 3 Intutvely, the government tryng to collect more revenue from ndutre that ue bank, whle avodng dntermedaton to the extent t can. Snce the frm ut ndfferent to ung bank are more labor ntenve than thoe already ung bank, the Th mpoe a mnmum average exponental growth rate for the functon (a (b)) Negatve ale taxe (ale ubde) are preumably nfeable, gven the potental for repeated trade of the ame good. 3 The common ue of deprecaton rather than expenng for captal under the VAT n poorer countre alo content wth th argument. 4

15 margnal frm are relatvely more concerned about ale tax rate, compared wth captal tax rate, than the nframargnal frm. Cuttng ale tax rate and rang captal tax rate therefore can rae revenue wthout nducng dntermedaton. A mlar argument mght be made for mpong a labor ncome tax on ut the hghet earner. Lke a tax on captal ncome, th would help focu taxe on frm mot ted to ung the fnancal ector f hgh-klled worker are complementary wth captal n producton. Optmal Ue of Tarff So far, we have gnored the poblty of taxe on mport or export. When would trade dtorton be ued, aumng a before that the country a prce-taker n the world market for all good? Wth no contrant on ale tax rate on conumer good, then the reult n Damond-Mrrlee (97) forecat producton effcency, requrng that the relatve prce faced by dometc producer equal thoe prevalng on the world market. When tax rate are contraned by the threat of dntermedaton, though, forecat change. In partcular, when dometc ale tax rate are hgh n ome ndutre, and low n other, then there an effcency gan from ung tarff to hft dometc producton toward the hghly taxed ndutre. Such tarff necearly change relatve conumer prce, however, whch may or may not be dered. To conder thee queton more formally, aume for mplcty that, gnorng tarff, the country would produce nonzero amount of two homogeneou good. 4 expendture are taxed at ome rate t Captal, whle condtonal on t each ndutry face a maxmum ale tax rate max, wth <. 5 Aume that the country export the max max 4 Th n fact tronger than needed. We only need to aume that both good are produced at the equlbrum tarff rate. 5 max b Wth t k > 0, equaton () become = [ a ( tk / r) ] /( a ). 5

16 frt good, and mport the econd good. Import of good are ubect to a tarff at rate, whle export of the frt good are untaxed. Denote mport of the econd good by M, and denote dometc conumpton of the two good by C. Dometc conumer prce then equal p and p ), whle the prce ( faced by dometc producer equal p ( ) and p ( )( ). To mplfy notaton, let f f and f ( ) f, where f contnue to denote dometc output n ndutry. In ettng tax and tarff rate, we follow conventon and aume that the government maxmzng a tandard repreentaton of ocal welfare: 6 (3) W = max V ( p, p ( ), w, r) U( p f t p M ), Here, V (.) = max V ( p, p ( ), w, r) U( p ( f C )),. the ndrect utlty a repreentatve redent receve from prvate ector actvty, U(.) repreent the utlty from publc expendture, and the aggregate captal tock. Gven the overall dometc budget contrant, government tax revenue equal the value of dometc output at world prce net of the value of dometc conumpton: p ( f C ). The government maxmze th ubect to the contrant that < max, for any gven t. The reultng frt-order condton for (4) f U ' p C r = VI pc w L = V I p( M f ) 6 A Levathan government a pecal cae n whch V 0. 6

17 7 where I V meaure the margnal utlty of ncome, and L the aggregate labor upply. 7 The ndvdual collectve budget contrant equal t L f p L L f p C p C p = ), ( ) )( ( ), ( ) ( ) ( mplyng that (5) = t r L w C p f M p C f p ) ( ) ( ) )( ( f p t Subttutng equaton (5) nto equaton (4), we fnd that (6) ) )( ( ) ( ' f p C p f M U V I 0 ) ( = t r L w t. Here, the frt term meaure the net welfare effect of a lump-um tranfer of a partcular amount from redent to the government. The econd, fourth, and ffth term are tandard meaure of the margnal exce burden arng from behavoral repone, gven preextng tax dtorton from tarff, captal taxe, and ale taxe. The remanng thrd term meaure the net effcency effect arng from change n the compoton of producton. Focu frt on the more conventonal tuaton where the contrant on the are not bndng. For a gven value of, conumer prce are fxed. Conder the et of coordnated change n,, and t that leave unchanged the net factor prce faced 7 The econd lne follow from dfferentatng the frm budget contrant t r wl f p f p k ) ( ) )( ( ) ( =, ung the envelope condton.

18 by ndvdual (r and w), but affect the compoton of producton. 8 Wth any uch combned tax change, the factor and good prce faced by conumer all reman unchanged, o that the C reman unchanged. The compoton of producton change, however. Wth government revenue equal to p ( f C ), taxe wthn th et hould then be choen to maxmze p f. Th occur f the relatve output prce faced by frm equal the relatve nternatonal prce for thee good, requrng that ( ) = ( )( ). Producton would then be effcent at the optmal choce for,, and t, for any gven value of : th the Damond-Mrrlee reult. Wth unretrcted tax rate, therefore, the thrd term n equaton (6) drop out. The optmal tarff rate determned by the remanng term n equaton (6). The preumpton n the optmal tax lterature 9 that the optmal commodty tax rate hould be approxmately equal, mplyng that 0, o that 0. When ale tax rate are contraned by equaton (), however, then there are two new factor puhng for ue of tarff. Frt, wth tax rate contraned, the margnal value of government revenue re (the rato V I /U' fall), rang the value of other ource of revenue. Th ha been a common ratonale for tarff n the pat. 8 For example, wth a gven ncreae n the tax rate on the labor-ntenve ector and a utably larger ncreae n the tax rate on the captal-ntenve ector, the market clearng wage rate can reman unchanged but the equlbrum value of r ( t ) fall. The return to avng, r, can then be left unchanged through a utable cut n t. However, thee combned tax change caue a hft n producton toward the laborntenve ector. 9 Corlett and Hague (953) how that optmal commodty tax rate are equal f good are equally ubttutable wth leure, whle Atknon and Stgltz (976) how that th hold f the utlty functon weakly eparable between leure and conumpton. Hatta (986) how that any devaton from equal rate hould be mall even f the utlty functon unretrcted. 0 Intutvely, gven uch eparablty n the utlty functon, the effect of tarff on factor upple are equvalent to what can be accomplhed ung a partcular et of factor taxe yeldng the ame revenue, o that the frt and lat two term n equaton (6) together um to zero. Wth only the econd term remanng, the optmal tarff rate equal zero. See, for example, Campllo and Mron (997). 8

19 In addton, a een n the thrd term of equaton (6), ue of tarff to ncreae producton of good provde a net gan to the extent that ( ) > ( )( ). By taxng mport of good, dometc producton hft toward the more heavly taxed commodty, offettng a preextng dtorton. Thee gan n producton effcency are then traded off wth net loe from dtortng relatve conumer prce away from what would have been dered. Note that even nontarff barrer may be ued, f tarff are unavalable, e.g. due to nternatonal trade agreement. A margnal ncreae n nontarff barrer generate no drect tranfer of revenue to the government, elmnatng the frt two term n equaton (6). The remanng term, however, may tll utfy ome level of nontarff barrer, n order agan to hft dometc producton toward the more heavly taxed ector. Yet another way to hft producton toward ndutry to ubdze nput ued prmarly by ndutry, or tax nput ued prmarly by ndutry. An example would be a ubdy to ue of energy. If energy ued much more ntenvely n captal-ntenve frm, then a ubdy to mport of energy make ndutry more proftable, generatng a hft n reource toward ndutry. Such a ubdy attractve f the net ocal cot of the ubdy needed to nduce a gven margnal ncreae n f le than the net ocal cot of ncreang tarff (or nontarff) barrer yet further. If the more heavly-taxed captal-ntenve good exported ntead, o that >, then the thrd term n equaton (6) negatve. If th term large enough, the optmal tarff on mport of good can alo be negatve, lowerng the market prce of good and hftng dometc reource nto added producton of the more heavly taxed good. Whether a country would be expected to encourage or dcourage trade can then depend heavly on whether producton of the exported good taxed at a hgher or lower tax rate than the good competng wth mport. Other Aumpton about Factor Affectng Obervablty 9

20 Our aumpton that the government can fully oberve ale and proft for frm that ue bank clearly heroc, partcularly gven the maor problem even the U.S. government ha n controllng tax avodance by large corporaton. A weaker aumpton that the government mply know of the extence of a frm f t ue a bank. Inpector can then vt the frm to learn more, n the proce perhap obervng only and the number of worker, ay N. nvolve heavy taxaton of Snce we argued above that the optmal tax tructure would lkely, even f f and L were alo obervable, the outcome can be cloe to thoe above. If only the number of worker oberved, though, and not L or f, th doe undermne effectve ue of a ale tax. Qualtatve reult alo reman largely unchanged f we conder other tylzed decrpton of the ource of nformaton for the government tax authorte. Conder for example the alternatve aumpton that the government oberve a bune only f t own land (e.g. a mne or ol depot) and/or operate out of a factory or offce buldng, gvng t a vble fxed locaton. To tranlate prevou notaton, let β = f a frm own a buldng or land, and aume that havng uch a fxed place of bune rae output by the fracton a. If a bune vble, aume agan that the government can oberve t entre captal tock,, and t number of worker, N. Then the formal conderaton affectng the choce of the tax tructure reman exactly the ame. 3. Implcaton for other polce Inflaton Taxe Many other puzzlng polce can ealy make ene once the government problem obtanng nformaton about economc actvty are recognzed. Conder the choce of an nflaton rate. The taxed ector, gven that t make ue of the bankng ector, The value of output would be more dffcult to oberve. 0

21 preumably largely protected from an nflaton tax, nce n equlbrum t bank depot hould earn a hgher nomnal nteret rate, reflectng expected nflaton. The untaxed ector, however, by contructon rele heavly on cah tranacton, makng t partcularly vulnerable to an nflaton tax. Snce an nflaton tax ha a much larger mpact on the unmontored ector than on the taxed ector, t can well generate an effcency gan offettng the cot focued on by Fredman (969) and Feldten (997). To begn wth, nflaton rae the cot of bune wthn the untaxed ector, caung thee frm to hrnk, leadng captal and labor nput to be reallocated to the taxed ector. Snce there were too few uch nput n the taxed ector to begn wth, due to taxe, th reallocaton at the margn an effcency gan. In addton, frm that would otherwe ue cah tranacton may ntead hft to ung bank a ntermedare, n order to avod thee cot. Th hft agan an effcency gan, due to both the value a f provded by fnancal ntermedaton and the elmnaton of nflaton dtorton n th ector. Thee effcency (and revenue) gan can ealy be large enough to offet the tandard loe from nflaton, at leat for low rate of nflaton. The more reponve the allocaton of reource between the taxed v. untaxed ector to the nflaton rate, the tronger the cae for a hgher nflaton rate. The optmal nflaton tax lmted, though, by the poblty that dollar or ome other foregn currency replace the local currency, n order to avod the nflaton tax. Snce th currency ubttuton provde no further hft n reource toward the taxed ector but lead to a dcrete fall n egnorage revenue, the optmal nflaton rate capped due to th treat of currency ubttuton. Wth nflaton, the country need to allow for a teady deprecaton of the value of t currency n nternatonal market. Any attempt to tablze the currency, e.g. through a peg to the dollar or the euro, wll undermne ue of nflaton for dometc purpoe. 3 3 We thank Hazhou Huang for pontng out th connecton to exchange rate polce.

22 Smlar argument can be made for nflaton even n a developed economy context. Whle the nformal/cah economy much maller n mot developed econome, t tll ext. In addton, llegal actvty, e.g. the drug trade, rele on cah tranacton heavly to mantan anonymty. Inflaton then provde an alternatve way to dcourage uch llegal actvty, and one that may be cheaper at the margn than addtonal reource nveted n drug nterdcton. Thee gan mut be traded off agant the effcency cot from an nflaton tax n the ret of the economy. State Ownerhp of Frm Gven the reult from the tylzed model above that taxe on captal can become large when the threat of dntermedaton mportant, too lttle captal wll be nveted n the taxed ector. A dcued n Gordon, Ba, and L (999), one extreme repone to th tax-nduced mallocaton of captal tate ownerhp at leat of the mot captalntenve frm, n order to nduce thee frm to take nto account the beneft to the government from hgher tax payment. 4 Another repone, dcued n Gordon (003), government-ubdzed credt to the taxed ector for the purchae of new captal. Whle the government loe drectly from the ubdzed loan to the taxed ector, t gan from the reultng extra taxe on the new nvetment, and new producton. Even f the ubdy fully offet the revenue collected n preent value on the new captal nvetment, for example, the government can contnue to collect revenue on extng captal (and output) whle leavng undtorted the decon to purchae addtonal captal. Thee ubde confned to frm n the taxed ector can alo nduce more frm to on the taxed ector. Retrcton on Multnatonal The model alo ugget partcular type of retrcton on the actvty of foregn multnatonal wthn a country. Multnatonal would certanly be part of the taxed ector, f only becaue a multnatonal home country wll requre accountng frm to 4 Such tate ownerhp n poorer countre of large captal-ntenve frm qute common.

23 document the ncome and balance heet of the local ubdary, record that hould be avalable to the hot government. However, the multnatonal ha many opportunte to hft real and fnancal actvty acro countre, dependng on relatve tax rate, e.g. through ue of tranfer prcng. 5 Thee ncome-hftng opportunte are not a readly avalable to dometc frm wthn the hot country. 6 The mpact of multnatonal on dometc tax revenue depend on the taxe they pay compared wth the revenue lot from the reultng crowdng out of dometc taxable actvty. 7 If multnatonal ell good to dometc redent otherwe produced by taxable dometc frm, then ther effect on dometc tax revenue depend on the relatve taxe pad by the multnatonal compared to dometc frm a a fracton of ale. Due to ther greater ncome-hftng opportunte, multnatonal would commonly pay a lower effectve tax rate. Gven the lo of tax revenue from entry of multnatonal, retrcton on entry of multnatonal nto ector domnated by taxable dometc frm would be expected. 8 Alternatvely, the government can compenate for the avodance behavor of multnatonal by tryng to mpoe hgher tax rate on thee frm. If the reult at leat comparable revenue from foregn-owned producton to that lot from the crowdng out of dometc producton, then FDI could be welcome n thee ndutre. Government would tll gan revenue from the entry of multnatonal nto ector otherwe domnated by untaxed frm. In th cae, tax revenue ncreae by replacng untaxed dometc frm wth multnatonal that pay at leat ome tax. Even when multnatonal produce n ector domnated by taxed dometc frm, f the product produced by the multnatonal doe not crowd out the dometc producton, e.g. t exported wherea dometc producton old locally, then multnatonal could tll enter wthout a lo n government tax revenue. 5 See Gordon and Hne (00) for a ummary of the theoretcal and emprcal lterature n th area. 6 Even n the U.S., a documented by Grubert, Goodpeed, and Swenon (993), foregn ubdare pay much le n taxe than eemngly equvalent dometc frm. 7 Crowdng out can occur due to competton n both the good and the factor market. 8 Such retrcton may take the form of lmt on the fracton of a frm that can be owned by a foregn multnatonal n partcular ndutre, a long a mnorty ownerhp not uffcent to nduce uch tax avodance. 3

24 If the taxed ndutre cont of a few captal-ntenve frm and a compettve frnge of labor-ntenve frm, then the government ha a fnancal ncentve to adopt polce gvng the captal-ntenve frm monopoly power, drvng out the compettve frnge. Th make output of the taxed (captal-ntenve) frm le entve to tax rate, nce the taxed frm can no longer be undercut by the compettve frnge. Any reultng monopoly proft can be taxed away, o the key role of uch polce mply to help hft output from the untaxed compettve frnge nto the taxed hare of each ndutry. Red Tape Focued on the Untaxed Sector One other mechanm to offet the tax dtorton leadng to too few frm n the taxed ector to create nontax cot on thoe frm operatng or hopng to enter n the untaxed ector. For example, aume that the government can hre bureaucrat to montor (hound) untaxed frm, and attempt to collect tax revenue from thoe that already ext, and fee from thoe hopng to enter. 9 If the montor cannot themelve be montored, however, the government cannot collect revenue baed on what a bureaucrat learn frm by frm. However, t can collect an ex ante amount, baed on ay the ze of the ector over whch the bureaucrat ha authorty, and then allow th ex ante payment to be et by market force. In equlbrum, competton among potental bureaucrat for the ob would lead to an ex ante net payment equal to the expected tax revenue collected mnu the opportunty cot of the bureaucrat tme. If potve, th could be a form of tax farmng. If negatve, th could nvolve a very low offcal alary for uch poton wth no offcal revenue generaton. A bureaucrat n uch a poton would want to maxmze the revenue collected. How much can be collected depend on what power the bureaucrat ha been gven, e.g. what threat are avalable. Wth full power, well-defned property rght to extort the frm, 9 By our admttedly extreme aumpton, the tax bae for frm ung bank cotlely obervable, through tabulaton of bank record. A a reult, there no gan from gvng tax npector the power to extort money from taxable frm the payment come out of tax revenue dollar for dollar. 4

25 and an unlmted tme horzon, the bureaucrat would act lke a Levathan government. Frm n prncple hould be able to ecape from th bureaucratc extorton by becomng part of the montored ector (n exchange of coure for becomng ubect to regular taxe). Th opton put an upper bound on what the bureaucrat n equlbrum can collect equal to the taxe due n the taxed ector mnu the effcency gan from ue of the bankng ector. If the bureaucrat become fully nformed and ha property rght to the frm evadng taxe, then the extorton would be ut low enough o that no frm would hft nto the taxed ector. 30 To what degree would a government chooe to hre bureaucrat n th fahon? By our aumpton, the bureaucrat mply earn her opportunty cot, o ndfferent to beng employed by the government. Aume n addton that the equlbrum alary of uch a bureaucrat potve, o that bureaucrat each collect le n revenue than ther opportunty cot. The government then loe revenue drectly from employng uch bureaucrat. Gven thee conderaton alone, bureaucrat are a pure ocal wate, harmng the frm they extort whle reducng the government revenue avalable to everyone ele. However, bureaucrat rae the cot of dong bune n the untaxed ector, caung thee frm at a mnmum to employ fewer nput. Th n telf lead to an expanon of the taxed ector, and to that extent an effcency gan. In addton, f the bureaucrat nformaton mperfect, ome frm wll hft nto the taxed ector, whch agan an effcency gan. Thee effcency gan may well be large enough to more than offet the ocal wate that reman preent. Other form of organzaton, e.g. makng the bureaucrat ob temporary or employng multple ndependent bureaucrat to hound the ame pool of untaxed frm, may provde larger gan. Wth a temporary ob, a bureaucrat ha an ncentve to eze what can be taken quckly, before the ob termnate, to the pont of confcatng anythng of value. 30 If the nformaton of the bureaucrat not perfect, then the bureaucrat would charge enough that at leat ome frm do hft nto the taxed ector. 5

26 Smlarly, a hown n Berkowtz and L (000), bureaucrat who compete n extractng rent from a common pool of untaxed frm together would mpoe a hgher effectve tax rate than would a Levathan government. Antcpatng th, otherwe untaxed frm would lkely ether not open or ele open olely n the taxed ector. Such extreme rapacoune then could nduce mot frm to on the taxed ector, or ele not enter. Th would be a more effcent outcome, nce tax polcy would no longer need to be aduted to deal wth the threat of dntermedaton. 4. Implcaton for the treatment of the fnancal ector In the above model, the fnancal ector play a crtcal role n the functonng of the tax tructure. The workng aumpton had been that the government ha acce to bank record on each frm, and can make ue of th nformaton n enforcng the tax law. Why hould bank be wllng to provde th nformaton? In partcular, any bank that can reduce the taxe that t cutomer owe ha a compettve advantage. In order to have acce to bank record, the government cannot rely on market force! State ownerhp of the bank one extreme polcy that can n prncple aure that bank make nformaton avalable to the government. Another approach ue of bank regulaton, whereby any bank that refue to cooperate wth the tax authorte loe t lcene to functon a a bank. Market force hould tll lead to the creaton of an nformal bankng ector that crcumvent thee regulaton, provdng fnancal ntermedaton wthout expong cutomer to tax lablte. In order to preerve t revenue bae, government would be expected to oppoe the development of uch an nformal fnancal ector. When t develop nonethele, t wll lkely facltate tax evaon. 6

27 Smlarly, government may mpoe captal control makng t dffcult for frm to hft ther depot abroad, nto foregn bank. Thee depot are preumably outde the purvew of the tax authorte, o ue of foregn bank undermne the tax ytem. To what degree hould the government encourage or dcourage branche of foregn bank from operatng n the dometc economy? For one, the bet of the foregn bank could provde much more value to cutomer (have hgher a ), o pull more frm nto the taxed ector. Such bank can gan a further compettve advantage, however, by enablng frm to hft ther fnancal record abroad, nto branche of the bank baed n other countre, where they can no longer by montored by the dometc tax authorte. It not urprng, gven the model here, that government often expre concern about the entry of branche of foregn bank nto the country, nce thee bank can undermne the entre dometc tax ytem. Under th tory, preventng foregn bank from takng depot uffcent to prevent tax evaon, and th a common retrcton. In fact, dometc-owned bank wth foregn branche create the ame rk unle the bank regulaton effectve enough. The tax treatment of bank alo nteract crtcally wth the tax ytem more broadly. If the bankng ector compettve, any taxe on bank n equlbrum mut be paed on to cutomer, reducng the gan, a, from ung bank, and thereby lowerng the feable taxe that can be collected drectly from frm. If a frm ue of bank proportonal to t taxable actvty (output or captal tock), then taxe on bank hould crowd out other taxe on frm dollar for dollar. 3 Th would lead bank facng uch a tax to report hgh pread between loan and depot nteret rate, to compenate for the tax. 3 Everythng ele equal, therefore, the more that revenue collected drectly from bank the lower the feable tax rate on captal expendture, and on frm more broadly. Bank taxe, though, do not allow for eparate tax rate by ndutry of depotor, makng them le flexble than ale or captal taxe. 3 For example, f all new nvetment by taxe d frm are fnanced by bank loan, then a tax on loan or ncome from loan equvalent to a tax on captal, yet may be eaer to admnter. 3 Thee large pread, per e, then need not be an ndcator of a poorly functonng fnancal ector. 7

28 5. Summary and dcuon The key hypothe of th paper that government need to rely on the nformaton avalable from bank record n order to dentfy taxable entte and to meaure the amount of ther taxable actvty. Frm then become ubect to tax f they chooe to make ue of the fnancal ector. When tax rate are hgh enough, frm ntead may forego the economc beneft from ue of bank n order to avod thee taxe. Th threat of dntermedaton may be of lttle mport n the rchet countre, where the value provded by fnancal ntermedaton conderable. In poorer countre, however, th threat of dntermedaton may be a key factor both lmtng the government ablty to collect tax revenue and hapng government polcy more generally. In partcular, baed on th hypothe about the role of bank n tax enforcement, we have derved the followng forecat for countre where bank provde only modet value added: a) Tax revenue a a hare of GDP wll be low, contraned by the threat of dntermedaton. b) The tax bae wll be narrow, confned to captal-ntenve frm that partcularly value the ue of fnancal ntermedare. c) The optmal tax tructure wll put ubtantal weght on captal ncome taxe, n order to focu the tax burden on thoe frm leat wllng to forego ue of the fnancal ector. d) Tarff wll be ued to protect the taxed ector. 8

29 e) Inflaton wll be ued a an ndrect mean of taxng the untaxed (cah) economy. f) Entry of foregn frm may be retrcted n thoe ector ubect to tax, but be encouraged n otherwe untaxed ector. g) Entry of foregn bank wll be partcularly dcouraged, gven the eae wth whch foregn bank can facltate tax evaon by dometc frm. h) Red tape retrctng actvty n the untaxed ector lkely. Accordng to the model, all of thee polce are optmal, gven any tandard government obectve functon, to the extent that the threat of dntermedaton (and the reultng tax evaon) mportant, rang queton about recommendaton to avod uch polce. Free-trade agreement, for example, are commonly defended a a mean of elmnatng cotly dtorton that lmt the degree to whch countre can take advantage of gan from trade. In our ettng, however, the dometc tax ytem put captal-ntenve ndutre at an artfcal dadvantage n nternatonal market, o that further trade can ealy reduce effcency, and reduce the feable amount of tax revenue that the government can collect. Recent free-trade agreement have gven partcular weght to openng up market for nternatonal trade n fnancal ervce. Accordng to our model, entry of foregn bank can erouly undermne a country dometc tax ytem, by makng t eaer for dometc frm to hde ther actvty from the government through hftng ther fnancal account abroad. Smlarly, nflaton can ealy be argued to create ubtantal cot, e.g. through makng long-term contractng very dffcult. In our ettng, nflaton alo create offettng 9