Designing turnover taxes in countries with large informal sectors

Abstract

Turnover (sales) is frequently used in developing countries as a presumptive income tax base to economize on the costs of tax administration and taxpayer compliance. We construct a simple model where a size threshold separates firms paying turnover tax from those paying regular income tax and where firms have the option of producing in the untaxed, informal sector. The optimal turnover tax rate trades off two policy concerns: reducing informality and avoiding strategic reductions in sales by firms seeking to remain below the threshold for the regular income tax. We provide analytical results and calibrate the model to compute the optimal policy using realistic parameter values. Introducing an optimally designed turnover tax induces about 12 percentage points of previously informal enterprises to register for the presumptive regime in the calibrated model.