Tax bunching at the Kink in the Presence of Low Capacity of Enforcement: Evidence From Uruguay

A first-order policy issue in low and middle income countries is how to design optimal tax systems in order to improve the state’s potential of supporting economic development. Although information regarding behavioral responses to taxation is a key input for tax design, the evidence in developing contexts is still scarce. In this paper we contribute to fill this gap by exploring in detail how individual taxpayers respond to personal income taxation in Uruguay. To do this, we rely on rich administrative tax records covering the universe of Uruguayan taxpayers and implement a bunching design. First, we find a moderate implied elasticity of taxable income (0.16) in the first kink point of the tax schedule. Second, we investigate the mechanisms driving these responses extensively. We find that the observed responses are a combination of both gross labor income and deductions responses. In particular, we document a more intensive use of personal deductions for taxpayers close to the kink point, and suggestive evidence of evasion responses through unilateral and employer-employee collusion labor income misreporting. Our results suggest that policy efforts should be directed at broadening the tax base and improving the enforcement capacities of tax authorities rather than eroding tax progressivity.