Greener on the Other Side: Inequity and Tax Compliance

Governments frequently use proxies for deservingness—tags—to implement progressive tax and transfer policies. These proxies are often imperfect, leading to misclassification and inequities among equally deserving individuals. This paper studies the efficiency effects of such misclassification in the context of the property tax system in Manaus, Brazil. We leverage quasi-experimental variation in inequity generated by the boundaries of geographic sectors used to compute tax liabilities and a large tax reform in a series of augmented boundary discontinuity designs. We find that inequities significantly reduce tax compliance. The elasticity of compliance with respect to inequity is between 0.12 and 0.25, accounting for half of the overall change in compliance at the boundaries. A simple model of presumptive property taxation shows how mistagging affects the optimal tax schedule, highlighting the opposite implications of responses to the level of taxation and to inequity for optimal tax progressivity. Interpreting our findings through the lens of the model implies that optimal progressivity is around 50% lower than it would be absent inequity responses. These results underscore the importance of inequity for public policy design, especially in contexts with low fiscal capacity.