Citation
Petrescu, Ioana Maria (2009). Income taxation and self-employment: the impact of progressivity in countries with tax evasion.Abstract
Recently several developing and transitional countries changed their personal income tax from fairly progressive to flat in an effort to improve efficiency. But how do taxes affect incentives when people can sometimes tax evade and pay bribes? In this paper, I address this question by focusing on the effects of personal income tax progressivity on the decision to become self-employed. I develop a theoretical model of tax evading self-employed individuals who pay bribes to tax authorities. The model predicts that progressivity affects the decision to become self-employed even if people tax evade. I then test this prediction empirically using three sources of data. First, I use Russian longitudinal data and estimate the effects of progressivity on the individual decision to become self-employed. Second, I construct a data set of personalincome tax schedules for 95 countries over 20 years and estimate the effects of progressivity on number of micro enterprises at the aggregate level. Third, I use Living Standards Measurement Surveys from 8 developing countries to estimate how much people are evading and the effect of progressivity on the amount that is not evaded. I find that increases in progressivity decrease the
probability of choosing self-employment and decrease the number of microenterprises. I also find that in countries with high tax evasion and frequent bribes, self-employment is less responsive to taxes than in the U.S.