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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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  • Sivadasan, Jagadeesh & Slemrod, Joel, 2008. "Tax law changes, income-shifting and measured wage inequality: Evidence from India," Journal of Public Economics, Elsevier, vol. 92(10-11), pages 2199-2224, October.
  • Handle: RePEc:eee:pubeco:v:92:y:2008:i:10-11:p:2199-2224
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    3. Richard Burkhauser & Shuaizhang Feng & Stephen Jenkins & Jeff Larrimore, 2009. "Recent Trends in Top Income Shares in the USA: Reconciling Estimates from March CPS and IRS Tax Return Data," Working Papers 09-26, Center for Economic Studies, U.S. Census Bureau.
    4. Mulholland, Sean, 2018. "Income Inequality in the United States," Working Papers 04022, George Mason University, Mercatus Center.
    5. 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.
    6. Jaan Masso & Jaanika Meriküll & Priit Vahter, 2011. "Gross Profit Taxation Versus Distributed Profit Taxation And Firm Performance: Effects Of Estonia’S Corporate Income Tax Reform," University of Tartu - Faculty of Economics and Business Administration Working Paper Series 81, Faculty of Economics and Business Administration, University of Tartu (Estonia).
    7. Harju, Jarkko & Matikka, Tuomas, 2013. "Entrepreneurs and income-shifting: Empirical evidence from a Finnish tax reform," Working Papers 43, VATT Institute for Economic Research.
    8. 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.
    9. Keuschnigg, Christian & Egger, Peter & Winner, Hannes, 2011. "Taxation and Incorporation," VfS Annual Conference 2011 (Frankfurt, Main): The Order of the World Economy - Lessons from the Crisis 48729, Verein für Socialpolitik / German Economic Association.
    10. Jarkko Harju & Tuomas Matikka, 2016. "Business owners and income-shifting: evidence from Finland," Small Business Economics, Springer, vol. 46(1), pages 115-136, January.
    11. 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.
    12. Egger, Peter H. & Erhardt, Katharina & Keuschnigg, Christian, 2020. "Heterogeneous tax sensitivity of firm-level investments," Journal of Economic Behavior & Organization, Elsevier, vol. 176(C), pages 512-538.
    13. Jarkko Harju & Tuomas Kosonen, 2012. "The Impact of Tax Incentives on the Economic Activity of Entrepreneurs," NBER Working Papers 18442, National Bureau of Economic Research, Inc.
    14. Tazhitdinova, Alisa, 2020. "Are changes of organizational form costly? Income shifting and business entry responses to taxes," Journal of Public Economics, Elsevier, vol. 186(C).
    15. Jarkko Harju & Tuomas Matikka, 2014. "Business Owners and Income-Shifting between Tax Bases: Empirical Evidence from a Finnish Tax Reform," CESifo Working Paper Series 5090, CESifo.
    16. 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.
    17. Alireza Shakibaei & MohammadReza Ahmadinejad, 2016. "Investigating the Structural Changes of Tax in Iran," Iranian Economic Review (IER), Faculty of Economics,University of Tehran.Tehran,Iran, vol. 20(4), pages 445-460, Autumn.
    18. Jarkko Harju & Tuomas Matikka, 2016. "The elasticity of taxable income and income-shifting: what is “real” and what is not?," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 23(4), pages 640-669, August.
    19. Hongbin Cai & Qiao Liu, 2009. "Competition and Corporate Tax Avoidance: Evidence from Chinese Industrial Firms," Economic Journal, Royal Economic Society, vol. 119(537), pages 764-795, April.
    20. Jarkko Harju & Tuomas Matikka, 2016. "Business owners and income-shifting: evidence from Finland," Small Business Economics, Springer, vol. 46(1), pages 115-136, January.
    21. Alireza Shakibaei & Mohammad Reza Ahmadinejad, 2016. "Investigating the Break and the Structural Changes of Tax in United States," Modern Applied Science, Canadian Center of Science and Education, vol. 10(8), pages 152-152, August.
    22. Cabral, René & García-Díaz, Rocío & Mollick, André Varella, 2016. "Does globalization affect top income inequality?," Journal of Policy Modeling, Elsevier, vol. 38(5), pages 916-940.
    23. Harju Jarkko, 2014. "Policy evaluation methods in tax research – new evidence and interpretations," Nordic Tax Journal, Sciendo, vol. 2014(1), pages 76-92, May.
    24. Matikka, Tuomas, 2014. "Essays on behavioral responses to income taxes," Research Reports P68, VATT Institute for Economic Research.

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    More about this item

    Keywords

    H24 H25 F13 Taxation Income-shifting Inequality Trade policy;

    JEL classification:

    • H32 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Firm
    • H25 - Public Economics - - Taxation, Subsidies, and Revenue - - - Business Taxes and Subsidies
    • F14 - International Economics - - Trade - - - Empirical Studies of Trade
    • O24 - Economic Development, Innovation, Technological Change, and Growth - - Development Planning and Policy - - - Trade Policy; Factor Movement; Foreign Exchange Policy

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