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The effects of size-based regulation on small firms: evidence from VAT threshold

Timo Rauhanen, Jarkko Harju () and Tuomas Matikka

No 75, Working Papers from VATT Institute for Economic Research

Abstract: Various types of size-based regulations for firms are typical in most countries (tax schedules, accounting rules, health and safety standards etc.). However, there is only limited evidence of how owners of small firms respond to such rules, and what are the underlying mechanisms behind the observed behavior. We study these questions by examining the effects of the value-added tax (VAT) sales threshold using tax register data on the universe of Finnish firms and their owners. We find sizable bunching of firms in the sales distribution just below the VAT threshold. This implies that small firms actively avoid VAT liability. We utilize variation in both the VAT rate and reporting requirements to provide compelling evidence that the response is caused by the compliance costs of VAT reporting rather than the size of the tax rate. This shows that the costs related to reporting and understanding taxes induce greater distortions than pure tax incentives, especially among low-income entrepreneurs. In addition, we find no explicit evidence of avoidance or evasion, which suggests that firms respond by reducing their true output. Also, bunching behavior is very permanent, implying that the VAT threshold hinders the growth of small firms.

Keywords: Value-added tax, compliance costs, small firms, entrepreneurs, bunching, Economic growth, Taloudellinen kasvu, Taxation, Verotus, H250 - Business Taxes and Subsidies including sales and value-added (VAT), H320 - Fiscal Policies and Behavior of Economic Agents: Firm, L110 - Production, Pricing, and Market Structure; Size Distribution of Firms (Concentration, Product Differentiation, Entry and Exit), D220 - Firm Behavior: Empirical Analysis, (search for similar items in EconPapers)
Date: 2016
New Economics Papers: this item is included in nep-acc, nep-ent, nep-iue, nep-pbe, nep-pub and nep-sbm
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