Tax Law Changes, Income Shifting and Measured Wage Inequality: Evidence from India

41 Pages Posted: 14 Jul 2006 Last revised: 27 Jul 2006

See all articles by Jagadeesh Sivadasan

Jagadeesh Sivadasan

University of Michigan, Stephen M. Ross School of Business

Joel B. Slemrod

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

Date Written: May 2006

Abstract

We use a large dataset covering all registered plants in the manufacturing sector in India over the period 1986 to 1995 to examine the effects of a 1992 income tax law change that eliminated the double taxation of wages paid to partners in partnership firms. This tax law change provides a unique opportunity to identify the effects of tax policy changes on firm behavior in a developing country context. Since the change provided incentives for shifting income from wages to profits, it also has important implications for certain measures of wage inequality. We find an immediate and pervasive response by partnership firms to the tax law change, reflected in a significant shifting of income from profits to managerial wages. Since about 50 percent of registered manufacturing plants are incorporated in the form of partnerships (including most family-run businesses), income shifting by these firms could have a significant impact on measured wage inequality. We find a sizeable jump in the mean and median relative wage of skilled workers (which includes managers and partners) following the tax law change in 1992. This sudden increase in measured wage inequality follows major trade liberalization and deregulation reforms announced earlier (in July 1991). We find that the income shifting induced by the tax law change explains almost all of the observed increase in measured wage inequality following these reforms. This finding is robust to inclusion of controls for a number of other potential sources of post-liberalization increases in wage inequality. Our results show that firms respond strongly to tax incentives for income shifting, and highlight the need to control for the potential effects of tax incentives in studies of wage inequality.

Suggested Citation

Sivadasan, Jagadeesh and Slemrod, Joel B., Tax Law Changes, Income Shifting and Measured Wage Inequality: Evidence from India (May 2006). NBER Working Paper No. w12240. Available at SSRN: https://ssrn.com/abstract=902592

Jagadeesh Sivadasan

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

701 Tappan Street
Ann Arbor, MI MI 48109
United States

Joel B. Slemrod (Contact Author)

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

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