Taxes, Informality and Income Shifting: Evidence from a Recent Pakistani Tax Reform

This paper analyzes the effects of personal income taxation on earnings, formality and business organization choices of agents. I use a tax reform introduced in Pakistan in 2009, which increased taxation of partnership firms substantially relative to other unincorporated firms, as a natural policy experiment to identify behavioral responses to taxation that include movement into informality, under-reporting taxable earnings, and income shifting to tax-favored business forms. Relying on administrative tax records that comprise the universe of income tax returns filed in 2006â11, I find that the tax rate rise caused the exit of a large number of treated firms: the number of such firms reporting positive taxable earnings declined by 41% in 2009, by another 27% in 2010, and by an additional 15% in 2011. By tracking personal income tax returns of owners of the exited firms, I find that around 45% of the owners moved into informality, the rest switched their business organization. For the treated firms that did not exit, I document almost 50% reduction in reported earnings compared to untreated firms. Combining these estimates of behavioral responses with a simple conceptual framework, I compute that 133% of the projected increase in tax revenue was lost through the behavioral responses, implying that the new tax rate on partnership earnings was on the wrong side of the Laffer curve and would not have been optimal under any social preferences. The excess burden created by the reform increases by nearly 17% if negative spillovers on VAT base are also taken into account.