Production vs Revenue Efficiency With Limited Tax Capacity: Theory and Evidence From Pakistan

To fight evasion, many developing countries resort to production-inefficient tax policies. This includes minimum tax schemes whereby firms are taxed on either profits or turnover, depending on which tax liability is larger. Such schemes create non-standard kink points, which allow for eliciting evasion responses to switches between profit and turnover taxes using a bunching approach. Using administrative tax records on corporations in Pakistan, we estimate that turnover taxes reduce evasion by up to 60-70% of corporate income. Incorporating this in a calibrated optimal tax model, we find that switching from profit to turnover taxation increases revenue by 74% without reducing aggregate profits, despite the production inefficiency that it introduces.