Corporate Taxation & Firm Size Distribution: Evidence from India

A common feature in the developing economies is that the firm size distribution tends to be bimodal. One among the many explanations is the corporate tax schedule, which creates incentives for some firms to bunch below a certain threshold. In such settings, it is important to account for such firm responses in order to determine the optimal corporate tax policy. The project focuses on the preferential tax treatment of small firms by the Govt. of Karnataka, India, which allows them to pay a turnover tax instead of a value added tax (VAT). Particularly, we would like to determine the threshold of preferential treatment that minimizes distortions in the firm size distribution, given the revenue requirements of the government. In order to determine this optimal threshold, we will explore the bunching behaviour of firms and their responses to changes in this threshold. This work contributes to a growing empirical literature on the optimal tax schedules in developing countries, and this would be the first work to characterize the optimal threshold of preferential treatment, conditional on being in the tax net. This is not only a key academic issue but obviously a massively important policy issue for promoting growth of businesses in developing countries.