Tax Policy and the Missing Middle: Optimal Tax Remittance with Firm-Level Administrative Costs

Abstract

We analyze the optimal taxation of firms when the government faces fixed (per-firm) administrative costs of tax collection. The tax instruments at the government's disposal are a fixed (per-firm) fee and a linear tax on output. If all firms in an industry are taxed, we show that it is optimal to impose a positive fee; this represents a Pigouvian tax that internalizes administrative costs. We derive an inverse elasticity rule that determines the optimal output tax for taxed industries; however, it is optimal to exempt industries with sufficiently high administrative costs. We also investigate the case where firms with outputs below a cutoff level can be exempted from taxation. We show that it may be optimal to set the cutoff high enough to exempt a sizable number of firms, even though this causes some firms to reduce their outputs to the cutoff level. This production distortion creates a missing middle, in which small and large firms - but not those of intermediate size - exist. The missing-middle phenomenon is common in developing countries; we demonstrate that it may result from optimal policies. The paper also presents a modified inverse-elasticity rule when output cutoffs are used, and it extends the analysis to include optimal nonlinear taxes on output.

Keywords: Optimal taxation, administrative costs, missing middle

JEL Classification: H21, H25, O17