Dynamics of Firm Growth around Tax Thresholds: Evidence from India 

Abstract

Promoting growth of small firms is an important policy concern. However, size-based policies can incentivize firms to remain below a threshold. Using the context of an Indian revenue-based tax registration threshold that affected only manufacturing firms but not services firms, coupled with administrative tax data, we examine how firm growth responds to the threshold. We find that firms respond by slowing down growth in reported revenue from far below the threshold. Our difference-in-difference estimates suggest this slowdown to be around 14 percentage points or roughly 42% of average growth. A lack of corresponding change in reported costs, along with heterogeneity analysis suggests an evasion response rather than a real response by firms. We modify the standard Allingham-Sandmo model of evasion to calculate deadweight loss due to a threshold in a dynamic setting and find that the welfare cost of a threshold can be substantial in the long run.

Keywords: Bunching, Excise Tax, Firm Growth, Elasticity of Taxable Income

JEL Classification: H25, H26, D61, K34