Tax Reform, the Informal Economy, and Bank Financing of Capital Formation
41 Pages Posted: 26 Mar 2011 Last revised: 26 Jun 2012
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Tax Reform, the Informal Economy, and Bank Financing of Capital Formation
Tax Reform, the Informal Economy, and Bank Financing of Capital Formation
Date Written: March 1, 2011
Abstract
This paper develops a model that relates entry into the underground economy to tax rates and the need to access the banking system. The model uses a dynamic approach in which both firms and banks optimize and in which the benefits to a firm of accessing the banking system are endogenous. A firm compares the return to capital with the marginal tax rate on capital income and uses the difference to determine how much of the tax to pay. At the same time, banks use a firm’s capital tax payments, combined with the capital tax rate to obtain an estimate of the firm’s minimum capital value. If the firm pays at least some taxes then it will have access to the banking system, which will allow it to finance investment. If the firm pays no taxes, then it cannot access the banks and cannot invest. We compare the equilibria resulting from tax compliance and tax evasion.
We calibrate the model to the macro aggregates of the Russian economy, and analyze the effect of potential tax changes on the underground economy. We compute a dynamic equilibrium for our model, and note that it tracks the path of the Russian economy with some accuracy for the years 2001-2008. We then carry out a series of counterfactual simulations, first asking if noncapital intensive firms have an incentive to evade taxes under existing value added tax rates. We find that they do, and that the incentive would have been greatly reduced if the value added tax rate had been selectively reduced for the non-capital intensive sectors. We then ask what the effect would be if the corporate tax rate were raised on capital intensive sectors. The simulations indicate that the capital intensive sectors would not increase their entry into the underground economy.
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