Using Movement of Exemption Cutoff to Estimate Tax Evasion: Evidence from Pakistan

Exploiting asymmetry of effort and evasion costs, I develop a simple approach that can be used to estimate tax evasion accurately from taxpayers’ own declarations. The approach relies on the fact that the costs of evasion are roughly of a reverse-L shape, whereas the costs of effort are a smooth, continuous function of earnings. Using a series of sharp tax changes in the Pakistani personal income tax schedules and administrative tax return data, I demonstrate that agent behavior is strictly consistent with the prediction of the model and estimate that at least 70% of self-employment and 1% of wage income is evaded in the country.