The efficiency cost of tax enforcement: evidence from a panel of spanish firms

In modern tax systems, firms remit the majority of tax revenues raised by the government, which gives them opportunities to avoid and evade taxes by misreporting their activities. In this paper, we use a natural policy experiment to analyze how firms respond to different tax enforcement regimes. The Spanish Large Taxpayers’ Unit (LTU) monitors and enforces the taxation of companies with operating revenue above €6 million, resulting in more frequent tax audits and more information requirements for those firms. We exploit this discontinuity in enforcement intensity to estimate the impact of low enforcement on tax reporting behavior, using a panel dataset of financial statements for 85% of Spanish firms in the period 1999-2007. We apply two different identification strategies. First, we find an excess mass of firms locating (“bunching”) just below the revenue threshold. Based on the number of bunching firms, we estimate that firms reduce reported revenue by 1.4% to 7.5% to avoid falling in the high enforcement regime. Second, we run panel regressions with firm fixed effects and find that reported input costs do not respond significantly to the change in tax enforcement. This suggests that firms react to the enforcement discontinuity mostly by reporting lower revenues, without significantly distorting production. The efficiency costs of tax enforcement are thus likely to be small because tax evasion constitutes a reallocation of income to tax-evading firms. A back-of-the-envelope calculation shows that the loss in tax revenue due to tax evasion by non-LTU firms is, however, significant. In light of these results, we discuss potential reforms to improve tax enforcement policies.