The centre for tax analysis in developing countries

Overseas Development Institue Institue for Fiscal Studies

Two-tier tax systems and firms: evidence from Brazil

Simplified tax schemes are prevalent in many countries (Bird 2013). The details of simplified schemes vary in terms of what "regular'' taxes are, and how the simplified taxation replaces those taxes. A common form of simplified schemes are tax regimes tailored to small and medium enterprises (SME) due to compliance costs, and administrative constraints that make it costly for tax authorities to observe the tax base for enforcement (Slemrod, 2013). As a result, modern systems of firm taxation -- characterized by some combination of payroll, valued-added, and corporate income taxes whose statutory incidence falls on firms -- often exist alongside special, simplified tax regimes that rely on presumptive tax bases (e.g. a single turnover tax). Understanding the implications of such dual systems is particularly relevant for developing countries where turnover thresholds for these moderns systems tend to be high and a large number of firms are “de facto” exempt from taxes by operating informally.

Using administrative data to explore simplified tax schemes

This project uses novel administrative data on anonymized inter-firm trade linked to labour inputs from Sao Paulo, Brazil, to shed light on implications of such two-tier systems for firm growth, market competition and production decisions. We use novel administrative data from Sao Paulo (Brazil), including anonymized data on inter-firm trade, to shed light on these three effects. First, we study how that the firm size distribution is distorted by the size-based eligibility threshold for the presumptive tax system. Second, we study how ineligible (larger) firms are affected by reductions in the tax burden for firms that opt in the presumptive system. Third, we study the relationship between tax systems and production choices through firm-to-firm trade and labour inputs.

Simplified tax schemes affect how firms grow and who they trade with

Our preliminary results indicate that a two-tier tax system – where some firms pay VAT, CIT and payroll taxes, while others pay a simple turnover tax – has important implications for firm growth, firm-to-firm trade and input choices. In particular, we find (partial) segmentation in the network between “regular firms” and firms in simplified regimes, i.e. firms trade relatively more with firms in the same tax regime. The degree of segmentation, however, is mitigated by the fact that firms are heavily dependent on key suppliers and buyers. In fact, most firms trade across tax regimes, and most firms have a regular firm among their main trade partners. Moreover, these potential distortions should be weighed against other key motivations for these two-tier tax systems such as compliance costs that could be quite large for small firms.

Published on: 13th September 2020

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