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

41 Pages Posted: 28 May 2008

See all articles by Dhammika Dharmapala

Dhammika Dharmapala

University of Chicago Law School

Joel B. Slemrod

University of Michigan, Stephen M. Ross School of Business; National Bureau of Economic Research (NBER)

John D. Wilson

Michigan State University - Department of Economics

Date Written: May 5, 2008

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

Suggested Citation

Dharmapala, Dhammika and Slemrod, Joel B. and Wilson, John D., Tax Policy and the Missing Middle: Optimal Tax Remittance with Firm-Level Administrative Costs (May 5, 2008). Available at SSRN: https://ssrn.com/abstract=1138015 or http://dx.doi.org/10.2139/ssrn.1138015

Dhammika Dharmapala (Contact Author)

University of Chicago Law School ( email )

1111 E. 60th St.
Chicago, IL 60637
United States

Joel B. Slemrod

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Room R5396
Ann Arbor, MI 48109-1234
United States
734-936-3914 (Phone)
734-763-4032 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

John D. Wilson

Michigan State University - Department of Economics ( email )

East Lansing, MI 48824
United States

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