Understanding fiscal capacity in developing economies: Firms as third-party tax enforcers

The difference in tax revenues (as a percentage of GDP) between developed and developing countries has always been consistently large. An IMF report estimates it to be 10-15 percentage points. The discrepancy poses two questions: 1. why can’t developing countries increase their fiscal capacity, and; 2. what makes advanced economies’ governments so successful in raising revenues? The first question leads to a list of challenges faced by developing countries, including: high level of informality and micro businesses, underdeveloped market institutions, limited financial development, low administrative capacity, heavy reliance on multinational firms, etc. The second question is the main focus of Kleven, Kreiner and Saez (2012) in their most recent IGC publication. There are two main aspects of modern governments’ fiscal capacity that the authors try to capture with a simple micro-founded agency model: a) government size (of current developed economies) has expanded dramatically over the 20th century; and b) government size has been stable since the 1970s. A central element to the expansion has been the ability to extract a substantial fraction of national products through taxation without destroying economic growth. In all advanced economies, most taxes are collected through third-party institutions, such as private or public employers, banks, investment funds, and pension funds, or what the authors call “firms” in their paper. Public finance literature and tax practitioners agree that tax enforcement is excellent whenever third-party reporting is in place. Therefore, as a first approximation, tax enforcement is successful only when third-party reporting covers a large fraction of taxable income. Furthermore, the literature on tax evasion generates a key puzzle: why are compliance rates so high in developed countries given that audit rates and penalties for tax evasion are generally low? Kleven, Kreiner and Saez (2012) develop a microeconomic model to explain why third-party information reporting by firms dramatically improves income tax enforcement. Modern firms have a large number of employees and carry out complex production tasks, which require the use of accurate business records. Because such records are widely used within the firm, any single employee can denounce collusive tax cheating between employees and the employer by revealing the true records to the government. Moreover, collusion is also unlikely when governments offer a whistle-blower reward to induce insiders to denounce large-scale tax evasion within firms. The authors are able to show that if a firm is large enough, whistle-blowing threats will make tax enforcement successful even with low penalties and low audit rates. Embedding this micro model into a simple macroeconomic growth model where the size of firms grow with technological progress, the paper shows that as the size of firms increase, third-party tax enforcement is completely effective and the ratio of government size to GDP is socially optimal and stable over time.