Production versus Revenue Efficiency with Limited Tax Capacity: Theory and Evidence from Pakistan

To fight evasion, many developing countries use production-inefficient tax policies. This includes minimum tax schemes whereby firms are taxed on either profits or turnover, depending on which tax liability is larger. Such schemes create nonstandard kink points, which allow for eliciting evasion responses to switches between profit and turnover taxes using a bunching approach. Using administrative data on corporations in Pakistan, we estimate that turnover taxes reduce evasion by up to 60-70 percent of corporate income. Incorporating this in a calibrated optimal tax model, we find that switching from profit to turnover taxation increases revenue by 74 percent without reducing aggregate profits.