Tax policy and the missing middle: Optimal tax remittance with firm-level administrative costs

We analyze the optimal taxation of firms when the government faces fixed (per-firm) administrative costs of tax collection. The tax instruments at the government's disposal are a fixed (per-firm) fee and a linear tax on output. If all firms in an industry are taxed, we show that it is optimal to impose a positive fee to internalize administrative costs. The output taxes satisfy the inverse elasticity rule for taxed industries, but industries with sufficiently high administrative costs should be exempted from taxation. We also investigate the case where firms with outputs below a cutoff level can be exempted from taxation. It may be optimal to set the cutoff high enough to exempt a sizable number of firms, even though some firms reduce their outputs to the cutoff level, creating a “missing middle”: small and large firms – but not those of intermediate size – exist. Thus, this common phenomenon in developing countries may result from optimal policies. The paper also presents a modified inverse-elasticity rule when output cutoffs are used, and it extends the analysis to include optimal nonlinear taxes on output.