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Tax law changes, income-shifting and measured wage inequality: Evidence from India

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  • Sivadasan, Jagadeesh
  • Slemrod, Joel

Abstract

We examine the effects of a 1992 income tax law change in India that eliminated the tax penalty on wages paid to partners in partnership firms using a large dataset covering all registered plants in the manufacturing sector over the period 1986 to 1995. This tax law change provides a unique opportunity to identify the effects of tax policy changes on firm behavior in a developing country context. We find an immediate and pervasive response by partnership firms to the tax law change, reflected in a significant shifting of income from profits to managerial wages. Because about 50% of registered manufacturing plants operate in the form of partnerships (including most family-run businesses), income-shifting by these firms could have a significant impact on measured wage inequality. We find a sizeable jump in the mean and median relative wage of skilled workers (which includes managers and partners) following the tax law change in 1992. Although this sudden increase in measured wage inequality follows major trade liberalization and deregulation reforms announced earlier (in July 1991), we find that the income-shifting induced by the tax law change explains almost all of the observed increase in measured wage inequality following these reforms. This finding is robust to inclusion of controls for a number of other potential sources of post-liberalization increases in wage inequality. Our results show that firms respond strongly to tax incentives for income-shifting, and highlight the need to control for the potential effects of tax incentives in studies of wage inequality. Because wages received by partners were reported as business income on tax returns, the finding of an increasing share of top wage earners in total wages in India in the 1990s, documented by Banerjee and Piketty [Banerjee, Abhijit, and Thomas Piketty. 2005. "Top Indian Incomes, 1922-2000." The World Bank Economic Review 19 (1): 1-20.] using tax return data, is unlikely to be much affected by the tax reform we analyze here.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Public Economics.

Volume (Year): 92 (2008)
Issue (Month): 10-11 (October)
Pages: 2199-2224

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Handle: RePEc:eee:pubeco:v:92:y:2008:i:10-11:p:2199-2224

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Web page: http://www.elsevier.com/locate/inca/505578

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Keywords: H24 H25 F13 Taxation Income-shifting Inequality Trade policy;

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References

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Citations

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Cited by:
  1. Kazuki Onji, 2008. "The Response of Firms to Eligibility Thresholds : Evidence from the Japanese Value-Added Tax," Finance Working Papers 21965, East Asian Bureau of Economic Research.
  2. Jarkko Harju & Tuomas Kosonen, 2013. "The Impact of Tax Incentives on the Economic Activity of Entrepreneurs," CESifo Working Paper Series 4259, CESifo Group Munich.
  3. Richard V. Burkhauser & Shuaizhang Feng & Stephen P. Jenkins & Jeff Larrimore, 2009. "Recent Trends in Top Income Shares in the USA: Reconciling Estimates from March CPS and IRS Tax Return Data," NBER Working Papers 15320, National Bureau of Economic Research, Inc.
  4. Jaan Masso & Jaanika Meriküll & Priit Vahter, 2011. "Gross profit taxation versus distributed profit taxation and firm perfomance : effects of Estonia,s corporate income tax reform," Bank of Estonia Working Papers wp2011-02, Bank of Estonia, revised 27 Apr 2011.
  5. Christian Keuschnigg & Peter Egger & Hannes Winner, 2010. "A Theory of Taxation and Incorporation," University of St. Gallen Department of Economics working paper series 2010 2010-25, Department of Economics, University of St. Gallen.
  6. Menon, Nidhiya & Rodgers, Yana van der Meulen, 2009. "International Trade and the Gender Wage Gap: New Evidence from India's Manufacturing Sector," World Development, Elsevier, vol. 37(5), pages 965-981, May.
  7. Peter Egger & Christian Keuschnigg & Hannes Winner, 2008. "Incorporation and Taxation: Theory and Firm-level Evidence," University of St. Gallen Department of Economics working paper series 2008 2008-20, Department of Economics, University of St. Gallen.
  8. Masso, Jaan & Meriküll, Jaanika & Vahter, Priit, 2013. "Shift from gross profit taxation to distributed profit taxation: Are there effects on firms?," Journal of Comparative Economics, Elsevier, vol. 41(4), pages 1092-1105.
  9. Anne Lauringson, 2011. "Unemployment Benefits In A Period Of Crisis: The Effect On Unemployment Duration," University of Tartu - Faculty of Economics and Business Administration Working Paper Series 82, Faculty of Economics and Business Administration, University of Tartu (Estonia).
  10. Keuschnigg, Christian & Egger, Peter & Winner, Hannes, 2011. "Taxation and Incorporation," Annual Conference 2011 (Frankfurt, Main): The Order of the World Economy - Lessons from the Crisis 48729, Verein für Socialpolitik / German Economic Association.
  11. Jarkko Harju & Tuomas Matikka, 2013. "Entrepreneurs and income-shifting: Empirical evidence from a Finnish tax reform," Working Papers 43, Government Institute for Economic Research Finland (VATT).

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