Tax cuts and compliance shifting across taxes

Tax compliance behavior of taxpayers in response to tax cuts has been a longstanding policy concern and research question. Previous literature has primarily examined the impact of tax cuts on compliance with a single tax, with limited attention given to compliance behaviors across multiple taxes within the same context. This paper addresses this gap by constructing a simple theoretical model to analyze how a reduction in the corporate income tax (CIT) rate influences firms’ compliance behavior regarding both the CIT and the social security payroll tax. We highlight a deduction-based mechanism in which social security payroll taxes are treated as labor costs and are deductible from the income-tax base, so that a lower CIT rate reduces the marginal cost of payroll tax evasion and thus incentivizes firms to evade social security payroll taxes. By utilizing a unique dataset of Chinese firms from 2005 to 2012 and employing a quasi-experimental design based on a distinctive feature of the 2008 CIT reform in China, our empirical results indicate that a decrease in the CIT rate reduces social security payroll tax compliance while simultaneously facilitating firms’ compliance with income taxation. These results provide evidence of compliance shifting between the CIT and social security payroll tax in response to tax cuts.