Tax Evasion, Disclosure, And

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World Development Vol. 36, No. 11, pp. 2512–2525, 2008
Ó 2008 Elsevier Ltd. All rights reserved
0305-750X/$ - see front matter


Tax Evasion, Disclosure, and Participation
in Financial Markets: Evidence from Brazilian Firms
United Nations Industrial Development Organization, Vienna, Austria
Summary. — This paper draws on survey data and qualitative evidence from Brazilian manufacturing firms to examine the scale and consequences of tax evasion at the enterprise level. It discusses
the costs and benefits of under-reporting from the entrepreneur’s perspective and provides evidence
that evasion of sales tax is only weakly correlated with firm size. The paper then shows that medium-sized and large manufacturing firms that evade taxes are less likely to undergo an external
audit and more likely to be asked for informal payments by tax officials. It also argues that they
may be less likely to participate in markets for equity finance.
Ó 2008 Elsevier Ltd. All rights reserved.
Key words — tax evasion, equity markets, Brazil, Latin America

This paper addresses the scale and consequences of tax evasion in Brazil at the firm
level. It is concerned with what has been called
the ‘‘unreported’’ economy—activity conducted by firms that are known to and registered with the authorities, but nonetheless
keep a fraction of their activities undeclared
for tax purposes (Feige, 1990). While most
firms engaged in such unreported activity tend
to be small, in some countries the sub-sector
can also include medium-sized and even large
companies, as this paper shows. Drawing on
data from the World Bank’s Investment Climate Survey (ICS) of Brazilian manufacturing
firms, the paper analyzes the costs and benefits
of tax evasion from the firm’s perspective and
makes two empirical points. The first is that larger Brazilian manufacturing firms declare a
greater proportion of their activities to the tax
and labor authorities, but that the difference
is small: a doubling of firm size is associated
with an increase of just 4 percentage points in
the fraction of sales reported. The second is
that firms that are evading taxes are less likely
to undergo an independent audit and also more
likely to be asked for informal payments by the
tax authorities. As a consequence of the former,
they may also be less likely to participate in
modern capital markets.

Tax evasion matters for several reasons. It has
consequences for resource allocation, enabling
non-compliant firms to draw labor away from
those that do pay taxes, and potentially shifting
resources into sectors more amenable to evasion, such as trade, services and construction.
To the extent that evading firms are constrained
in their access to sources of finance, as this
paper argues, they may also operate more
labor-intensively than would be optimal (Eilat
& Zinnes, 2002). They may also choose to operate at below optimal size, in order to avoid the
attention of the authorities (McKinsey, 2004,
p. 6). 1 More generally, tax evasion erodes the
state’s capacity to raise revenues and provide
necessary public services, placing an unfair burden on those individuals and businesses that do
pay their taxes. These consequences are of particular concern when evading firms compete
with compliant ones, or when tax and other
forms of regulatory evasion, such as smuggling,
* I would like to acknowledge the helpful comments
of Katrina Burgess, Daniel Geffen, Maddalena Honorati, Robert Kaufman, Richard Locke, Helen Milner,
John Nasir, Pablo Pinto, Graeme Robertson and two
anonymous reviewers for World Development. Part of
the work on which this paper is based was financed by
the Investment Climate Unit of the World Bank. Final
revision accepted: November 13, 2007.



become a source of competitive advantage. 2
Under these circumstances, the presence of a
large shadow economy can undermine the social
contract that exists between the state and compliant economic actors, potentially leading to
the disintegration of norms that encourage
compliance (Gerxhani, 2004).
The distorting influence of tax evasion on
factor markets indicates the need for a more
holistic approach to microeconomic reform in
developing countries. As an influential study
has put it, ‘‘Another set of big think questions
centers on the proposition. . . that the benefits
from any one set of reforms are significantly enhanced when other markets are well functioning. . . Comparative analysis of policy changes
in countries where polices toward other sectors
vary may yield valuable insights’’ (Krueger,
2000). This is of particular interest to a country
like Brazil, where access to finance is one of the
most severe firm-level constraints on economic
growth (World Bank, 2005). It should also be
of interest to policy-makers trying to stimulate
equity market development. The practical
implication is that reforms to capital market
regulation are unlikely to yield significant
growth in financial intermediation unless policy-makers also address the causes of tax evasion. This in turn requires a careful approach
that induces firms to comply with their tax
and regulatory obligations while avoiding driving them out of business altogether.
In the last few years, policy-makers, and
scholars have turned their attention to the micro-institutions of capitalism outside the
developed world. Following a wave of macroeconomic reforms in the 1990s, many development practitioners came to recognize the
importance of institutions and incentive structures in sustaining economic activity. Attention
therefore focused on what has come to be called
the ‘‘investment climate’’—the ‘‘opportunities
and incentives for firms to invest productively,
create jobs, and expand’’ (World Bank, 2005,
p. 19). Among the most important determinants of the investment climate is the scope
and quality of government regulation. There
is a long and distinguished literature on the
ways in which state institutions support market
activity: by channeling information about market conditions and participants, by defining and
enforcing property rights and contracts, and by


ensuring an appropriate level of competition
(World Bank, 2002, pp. 5–6). Unfortunately,
efficient states are a rarity in the developing
world. Most governments in these countries
dispose of the ability to issue regulations and
commands—what Mann called ‘‘despotic
power’’—but have little if any capacity to enforce them (Mann, 1984). The most extreme
manifestation of this failure is organized private thuggery of the sort that prevailed in
Somalia in the early 1990s. But a more common outcome is the growth of the unrecorded
or ‘‘gray’’ economy which characterizes a number of middle-income countries. In these countries much economic activity is unregulated and
or untaxed. As a recent analysis put it, ‘‘The
relationship between the informal economy
and the state is, by definition, one of inevitable
conflict. The whole point of the state is to assert
the monopoly of its authority within a territory,
but the whole point of informal entrepreneurs
is to avoid or subvert that authority. . . an informal economy will develop when and where it
can’’ (Centeno and Portes, 2003, p. 7).
The obvious question is what allows this situation to persist. One explanation is a simple
lack of capacity. To be effective, a tax administration must both make contact with potential
taxpayers and obtain information about the
scale of their activities. Doing so requires a high
degree of coordination and information-sharing among government departments, particularly the tax authorities and police. Even
advanced industrial countries have difficulty
in ensuring full compliance (OECD, 2004).
Achieving anything comparable is beyond a
developing country like Brazil, which spends a
much smaller proportion of national income
on tax collection and which lacks lawyers and
judges with tax expertise (McKinsey, 2004, p.
30). The identification problem is particularly
acute for smaller businesses. Survey data from
transition and from some African economies
show that smaller firms generally report a lower
fraction of their revenues to the authorities,
presumably because their size makes it easier
for them to deal in cash (Gauthier and Gersovitz, 1997; Gauthier and Reinikka, 2001; Gehlbach, 2004, 22). It is also more problematic for
labor-intensive businesses because they have
fewer visible fixed assets than capital-intensive
ones. Much unrecorded activity in developed
countries consists of labor-intensive services
such as construction, road haulage, contract
cleaning and catering (OECD, 2004, p. 262).
When enforcement capacity is limited, the tax



authorities may pursue a triage strategy—preferring not to pursue some firms because the
administrative costs of doing so outweigh the
revenue benefits.
But a second explanation is that firms are
able to evade taxation through political connections, bribery and other forms of manipulation.
In developing as in developed countries, large
firms often engage in sophisticated tax planning
and avoidance schemes. Studies in Cameroon
and Uganda have found that larger firms are
more likely to be granted exemptions and take
advantage of tax incentive schemes than small
and medium-sized enterprises (Gauthier &
Gersovitz, 1997; Gauthier & Reinikka, 2001).
But tax administrations often run into trouble
because they suffer from corruption within their
own ranks. This can take various forms—from
providing exemptions to firms and individuals
who would otherwise not qualify, to closing a
tax audit without any adjustment being made
or penalties being imposed, to deleting taxpayer
records altogether (Tanzi, 2003, p. 5). If the value of the tax foregone exceeds that of the
bribe, the arrangement can be to the benefit
of both parties—though not to the rest of society. If not, it can amount to an extortion racket
with low-level officials blackmailing firms into
paying bribes to avoid prosecution for evasion.
Whichever side of the debate one takes, the
scale of evasion is impressive. By one estimate,
unregulated activity accounted for more than
30% of all economic activity in the developing
world in 2003. Furthermore, the proportion of
output generated by firms that are wholly or
partly outside the regulatory system has increased over the past decade and a half: from
29% in 1990 to 38% in 2003 in Latin American
and the Caribbean, and from 28% to 36%
among developing countries as a whole, excluding China (Schneider & Klinglmair, 2004). Most
studies of regulatory non-compliance have focused on micro-enterprises and self-employed
individuals. But this focus may be misleading,
since the phenomenon extends well beyond
these categories of firms and workers. As the
World Bank has put it, ‘‘The informal economy
is diverse, ranging from subsistence farmers and
those engaging in entrepreneurship out of necessity, to more affluent firms that find it feasible to
evade tax and regulatory obligations, and others in the middle’’ (World Bank, 2005, p. 61).
In what follows I analyze the benefits and
costs of tax evasion from the perspective of
the firm, concentrating in particular on its consequences for the ability of these firms to partic-

ipate in the arms-length transactions that
characterize many markets, including those
for finance. The data on which the analysis is
based are drawn from Brazilian manufacturing
enterprises with 10 or more employees. They
therefore exclude the service sector, in which
the majority of Brazilian firms are located and
where we might expect tax evasion to be more
widespread, given their generally higher share
of labor in value added, lesser degree of reliance
on fixed assets, and consequent lower visibility. 3 Experience from the OECD suggests that
tax evasion tends to be much higher in these
sectors than in most manufacturing industries.
And anecdotal evidence from Brazil indicates
that the evasion of customs duties is prevalent
in retail trade and especially in the distribution
of beverages, cigarettes, fuel, pharmaceuticals
and processed food (ETCO, 2003).
Government regulation imposes costs on
firms and there are benefits to be derived from
evading it. Governments regulate companies in
all sorts of ways: to restrict who may enter a
market, to control where firms may locate or
to ensure minimum health, safety, and product
standards (World Bank, 2005, p. 95). The regulatory burden associated with doing business
varies significantly across countries, with work
by the World Bank suggesting that it is larger
on average in developing than in developed
countries. 4 In some countries firm managers
report spending over 10% of their time dealing
with government regulations and inspections
(World Bank, 2005, p. 100). The cost and time
involved in starting a business is also much
higher in low and middle income than in
developed countries—up to 100 times higher
in some cases according to the World Bank’s
Doing Business Survey (World Bank, 2005,
p. 99).
Governments in developing countries also
raise revenues from companies, generally
through sales or payroll taxes (World Bank,
2005, p. 106). Indeed, the fraction of revenue
derived from corporate taxes and levies on
commercial transactions tends to be higher in
developing than in developed countries, due
largely to inefficiencies in tax administration
of the type discussed above (World Bank,
2005, p. 107). From the firm’s point of view,
the problem is often not so much the level of
taxation—which is little different from that in


the developed world—but the difficulties and
inconvenience associated with its collection. In
several of the countries covered by the World
Bank’s Investment Climate Surveys, including
Brazil, over 50% of firms listed tax administration as a very severe or major obstacle to the
growth of their business (World Bank, 2005,
p. 109). The practical consequence, according
to some Brazilian entrepreneurs, is that evasion
has become a necessary condition for survival
(Lieberman, 2003, p. 231).
(a) What are the consequences of tax evasion for
But if tax evasion confers important benefits
on firms it also imposes significant costs. The
most obvious are those associated with discovery and prosecution: penalties in the form of
fines or confiscated assets (Loayza, 1997, p.
1). But there are other potentially more serious
consequences. These follow from two observations. The first is that evading firms do not typically have access to the courts or other dispute
resolution mechanisms, most of which are at
the disposal only of companies that operate legally (World Bank, 2005, p. 8). The second is
that evading firms also generally prefer to keep
a low public profile to avoid detection.
Lack of access to the courts can render
evading firms vulnerable to crime. It may also
restrict them to doing business with a circumscribed set of partners whom they consider
trustworthy, limiting the use of arms length
transactions or those based on disclosure and
transparency rather than personal acquaintance. This can have consequences for their
ability to enter into licensing agreements or
relationships with suppliers of capital equipment and technology. Firms that are evading
taxes and other government regulations may
also subject to extortion by agents of the state.
Macro level data suggest a strong correlation
between perceptions of corruption and the extent of the unreported economy, even after controlling for the level of income across countries
(World Bank, 1999, 20). This may be, as the literature on transition economies has emphasized, because firms pay bribes to officials in
order to avoid paying taxes. But it may also
be because evading enterprises are subject to
predation on the part of corrupt officials. Several studies have found a strong firm-level correlation between hidden activity and the
propensity to pay bribes (Johnson et al., 2000,
p. 513). 5


A further consequence of tax evasion is that
it may make it harder for firms to access external finance. Banks and other financial institutions are generally unwilling to grant credit to
firms that lack proper documentation, including that relating to government registration
and licensing. Meanwhile, participation in capital markets requires a level of disclosure that
many less modern and less well-organized firms
find difficult to meet, accustomed as they generally are to poor or non-existent book-keeping.
Moreover, listing on the stock market requires
companies to submit their accounts for external
auditing; in some countries it may also require
them to engage the services of outside directors.
By making their financial information publicly
available to investors, under-reporting firms
not only incur a substantial burden of regulation, they also are forced to state their earnings
transparently and open themselves to a more
rigorous assessment of their tax liabilities. 6
As a consequence, they may also be more likely
to finance themselves through retained earnings
or through informal sources, such as moneylenders, friends, and family.

Brazil makes a particularly good case for
examining the consequences of tax evasion at
the firm level. First, the scale of unreported
activity is larger than in most other countries.
According to one estimate, it accounts for
around 40% of Brazilian GDP, compared to
13% in China, 23% in India, and 30% in Mexico (Capp, Elstrodt, & Bebb Jones, 2005). Of
the countries covered by the World Bank’s
Doing Business Survey, only Russia had a larger unofficial sector—at just over 46% of gross
national income. And anecdotal evidence suggests that unrecorded and untaxed activity is
prevalent even among large firms. Lieberman
(2003), for instance, quotes an accountant from
an American-based Big-Six accounting firm in
the late 1990s as saying that most of his corporate clients paid ‘‘no income tax at all’’ (Lieberman, 2003, p. 229). There is also a particularly
large productivity differential between firms
that comply with government regulations,
including tax, and those that do not. According
to McKinsey, output per worker among the
former is on average 46% that of the latter
(McKinsey, 2004, p. 6).



Second, the retarding impact of evasion on
capital markets is probably more evident nowhere than in Brazil. According to the market
research firm IDC, there are about 6,000 companies in Brazil with over 250 employees, only
120 of which are listed and traded on the Sa˜o
Paulo Stock Exchange (Viegas, 2005, p. 1). In
2000, the ratio of stocks traded in relation to
GDP stood at 19%, compared to 40% in
Malaysia and 43% in South Korea (World
Bank, 2007). Anecdotal evidence points to tax
evasion as being one of the chief reasons: companies that do not pay taxes do not generally
keep reliable accounts and have an understandable aversion to outside scrutiny by banks or
other financial intermediaries. This is particularly troublesome for capital market development since the relationship between the issuers
and buyers of equity securities depends on a
high level of disclosure. Interviews with fund
managers in Sa˜o Paulo confirm the relevance
of these considerations. Many controlling
shareholders balk at undertaking a stock market listing or at selling control to an outside
investor when they realize that doing so would
require them to obtain an audit and settle their
tax liabilities—thus eroding their profitability
and the value of their stake in the company
by up to 30 or 40%. 7
Historically Brazilian companies have responded to the challenge of greater openness
by carrying multiple sets of books (known locally as ‘‘caixa dois’’). 8 They may also bribe
auditors to overlook tax evasion or other irregularities. But the tightening of reporting and
other requirements for participation in public
capital markets since the financial crises of the
late 1990s has raised the cost of these subterfuges. Companies wishing to list on the Sao
Paulo stock exchange must now meet a set of
criteria explicitly modeled on and as rigorous
as those required by the New York and London stock exchanges. These include the mandatory use of independent directors, the
presentation of certified accounts according to
US GAAP and stringent minority shareholder
protections. One consequence of this evolution
in corporate governance standards for listed
companies is that, as a recent Brazilian government report put it, the scale of tax evasion has
become ‘‘an obstacle to financial intermediation: it undermines the evaluation of credit risk
by banks, raises the cost of borrowing, and curtails the use of capital market instruments,
where transparency is a necessary condition
for efficiency’’ (Rocca, 2004, p. 24).

In what follows, I use the World Bank’s
Investment Climate Survey database to test a
series of firm-level hypotheses concerning the
relationship between tax evasion, access to formal markets for finance and business government relations. This database contains
responses from a random sample of firms on
various aspects of the investment climate,
including corporate governance, government
regulation, access to finance, physical infrastructure and labor relations (World Bank,
2005). Launched in 2001, the ICS data cover
both objective and perception-based indicators.
The objective indicators measure the time required to complete various processes and the
monetary costs of disruptions and regulations.
The subjective indicators cover firms’ perceptions of the constraints on doing business and
their assessments of various risks, including
those associated with tax and labor laws
(World Bank, 2005, p. 245).
The Brazilian survey was conducted in 2003
for a random sample of 1642 business entities
stratified by sector, location and size. As
already mentioned, all were manufacturing
firms and spanned the following activities:
food processing, textiles, garments, leather
and footwear, chemicals, metals and machinery, electronics, auto-parts and furniture.
They were also chosen to be the representative of the country’s five principal regions.
Consistent with the geographical distribution
of economic activity, 70% of firms were
drawn from the country’s relatively developed
south and south-east, while 17% were drawn
from the Amazon and center-west regions
and 13 from the poorer north-east. Entities
belonging to companies employing fewer than
ten workers were excluded. Of these 1642
businesses, 69 are listed publicly—representing approximately a fifth of the total listed
on the Sao Paulo stock exchange. These are
overwhelmingly privately owned companies,
most of them controlled by domestic Brazilian shareholders. Only four are majority foreign-owned and only one is wholly
government-owned. Of these domestic Brazilian shareholders, the majority are individuals
and families—not banks or institutional
investors, as might be the case in the United
States or some European countries. The listed
companies themselves range in size from 11
employees to over 6,000.


As the sample frame was based on official
statistics, the survey tended to over-sample
registered and, possibly by extension, tax
compliant firms. Since in Brazil, as in many
other countries, the size distribution of firms
is skewed toward micro and small enterprises,
the survey also over-sampled large firms to
ensure a minimum number of respondents
in each size category to allow for meaningful
analysis. This means that we should be careful about extrapolating the results to other
firm populations, including those in service
industries as already mentioned, but also
the micro-enterprise sector or unregistered
firms. 9
(a) Hypotheses
First, I am interested in the degree of reported tax evasion among respondent firms.
What is the distribution and how does it vary
by size and sector? Is it true that smaller
firms are more likely to evade than larger
ones? Second, I am interested in whether
firms that are evading taxes are less likely
to have their accounts certified by external
auditors and whether, as a consequence, they
are less likely access markets for equity finance and more likely to rely on informal
sources of funds. Third, I am interested in
the relationship between firms and the state
agencies responsible for tax and administration. Are firms that are evading taxes more
or less likely to face demands for informal
payments from government officials and do
they have more or less confidence in their
capacity to influence regulations that affect
their business? These questions are captured
in the following hypotheses:
H1: The distribution of tax evasion across firms
is a continuous not a binary variable; smaller
firms should report higher levels of evasion
H2: Firms that are evading taxes and labor regulations will be less likely to have their accounts
audited by an external auditor
H3: Firms that are under-reporting sales will be
less likely to issue new shares and more likely to
rely on informal sources of finance
H4: Firms that are under-reporting sales will be
more likely to receive demands for informal payments from government inspectors
H5: Firms that are under-reporting sales will report less influence over the content of regulations
that affect their business


(b) Variables and specification
The variables I use in the analysis are defined
below. Survey questions are reported in Table
1. In the regression analysis that follows, I employ a simple specification of the type:
Y ¼ a þ b1½tax compliance
þ b2½control variables þ e:
I use OLS estimation where the dependent variables are continuous, that is, for hypotheses (1)
and (3), probit where the dependent variable is
binary, that is, for hypotheses (2) and (4) and
ordered probit where the dependent variable
is categorical and orderable, that is, hypothesis
(5). The data are cross-sectional and unstandardized.
(c) Independent variable
(i) Tax evasion
Obtaining reliable data on the extent of tax
evasion is notoriously difficult, since firms have
an understandable aversion to acknowledging
it. Instead, the survey asks respondents a leading question designed to elicit information
about their own behavior while purporting to
be about that of their competitors. The question about tax compliance is worded as follows:
‘‘Recognizing the difficulties many enterprises
face in fully complying with taxes and regulations, what percentage of total sales would
you estimate the typical establishment in your
area of activity reports for tax purposes?’’ I
take this as a proxy for the level of compliance
practiced by the respondent firm itself, anticipating that the firm will take its own practice
as a baseline. Naturally, this assumption is
open to question. It might be, for instance, that
respondent firms deliberately overstate the degree of compliance out of fear of the authorities. To counter this, the survey enumerators
made clear to surveyed firms that the firm conducting the survey was private, unconnected
with the tax authorities and that the data would
be disseminated only in such a way as to make
it impossible to identify firms from their
responses. 10
(d) Dependent variables
(i) Aversion to disclosure
I am interested in the extent to which the firm
is willing to grant access to outsiders, the


Table 1. World Bank investment climate survey questions

Tax evasion:
Recognizing the difficulties many enterprises face in fully complying with tax and other regulations, what percentage of total annual sales would you estimate the typical establishment in your sector reports?
Aversion to disclosure:
Does your establishment have its annual financial statement checked and certified by an external auditor? [Yes,
Sources of finance:
What percentage of your new investment and working capital requirements over the past year was financed from
new equity or the sale of stock?
What percentage of your new investment and working capital requirements over the past year was financed from
informal sources (e.g., moneylender)?
Corruption and influence:
During the last year, did anyone [from the federal/state/municipal tax authorities] suggest that you make an informal payment (gratuity or tip)?
How much influence do you think your firm had on recently enacted national laws and regulations that have a
substantial impact on your business? [1 = none, 2 = minor, 3 = moderate, 4 = major, 5 = decisive]
Source: World Bank investment climate surveys, available at

assumption being that firms that are evading
taxes will be wary of disclosure. The indicator
I use is whether the firm’s accounts were audited by an external auditor.
(ii) Use of external finance
I am interested in the degree to which firms
are able to tap formal markets for finance,
particularly equity finance. My variable is
the proportion of the firm’s working capital
and investment requirements that is met by
the issuance of new shares. Unfortunately,
the ICS dataset does not distinguish between
equity raised on public capital markets and
that raised through the sale of shares to individuals. To further assess the reluctance of
evading firms to draw on formal sources of
finance, I also include the percentage of
working capital and investment requirements
met through ‘‘informal sources (such as a
(iii) Experience of corruption
The ICS dataset includes several questions
concerning relations between firms and government inspectors. My variable indicates whether
or not the firm was, within the previous year,
asked for a gift or informal payment by officials
from the federal, state or municipal tax authorities. (Specifically, the question was worded as
follows, ‘‘Did anyone suggest you make informal payments (gratuities or tips)?’’). It does
not indicate whether such a payment was in
fact made or not. 11

(iv) Influence over policy
I am also interested in the extent to which
firms have a say in policy-making. I use the
firm’s own assessment of the extent to which
it was able to influence ‘‘recently enacted national laws and regulations that have a substantial impact on [its] business.’’ This is coded on a
scale from 1 to 5, with 1 representing ‘‘no influence’’ and 5 representing ‘‘decisive influence.’’
(e) Controls
Probably, the single largest difficulty in
assessing the impact of tax evasion on firms’
participation in formal markets is endogeneity.
The same factors that lead firms to evade tax
may also lead them to eschew external audits
and markets for finance. Firms in labor-intensive industries, for instance, might be both better equipped to hide from the authorities and at
the same time less in need of external finance
than more capital-intensive firms. Capitalintensive firms, or those with a higher proportion of fixed assets, might also find it easier to
provide collateral (and therefore be less dependent on informal sources of finance). Similarly,
firms in areas of the country with relatively
poorly developed formal institutions might be
subject to less rigorous tax enforcement and
at the same time lack information about or access to formal markets for finance. Another two
potential sources of endogeneity are size and
ownership structure. Other things being equal
I would expect larger firms both to have greater


access to capital markets and to be more visible
to the tax authorities. The same may be true of
exporters and foreign-owned companies.
I address these issues through control variables. For labor intensity, I include the share
of wage costs—defined as salaries plus social
security and other contributions—in total production costs, measured at the firm level and
obtained through the ICS survey instrument. 12
To control for differences in the availability of
collateral, I include the proportion of fixed assets (machinery, equipment and land) in total
assets. I also control for variations in the
overall institutional environment by including
state-level per capita output, as reported by
the Brazilian Institute for Geography and
Statistics (IBGE). Finally, I include firm size,
as measured by the log of the number of
employees, the proportion of the firm’s output
that is exported (either directly or through a
distributor) and the proportion of its capital
that is foreign-owned. The latter three variables
are self-reported by firms in the ICS. 13 Table 2
reports the correlations among these control
(a) Descriptive statistics
Several preliminary results emerge from the
descriptive statistics. The first is that there is
a substantial variance in the level of reported
compliance, consistent with the view that evasion is a matter of degree not kind. As Figure
1 shows, the likelihood of a firm reporting
50% or 70% of its sales is almost as great as
that of it reporting 100% (around 16% com-


pared to 19%). Meanwhile, Figure 2 shows
that the reported tax evasion occurs among
all sizes of firm, even large enterprises. While
the degree of under-reporting is highest among
firms with fewer than 20 employees, even large
firms—with more than 100 employees—typically only declare around 75% of their sales
to the authorities. The regression results reported in the first column of Table 5 provide
additional support for this finding, which is
robust to the inclusion of appropriate control
variables. They imply that the hypothetical effect of doubling firm size is to increase the
fraction of sales declared by only 3.8 percentage points (note that the size variable is
expressed as the natural log of the number
of employees). In short, larger firms are more
likely to report their peers as complying with
tax requirements than smaller firms but the
difference between them is not great. 14
The level of reported tax evasion varies quite
substantially across sectors, as shown in Table
4. It is highest in the garments, leather and furniture industries, lowest among electronics,
chemicals, and manufacturers of auto components. This is broadly consistent with the
hypothesis that there are greater opportunities
for evasion in labor intensive as opposed to
capital-intensive sectors—and is supported by
the negative coefficient on labor intensity in
the OLS regression results reported in Table
5, column 1, which implies that a 5 percentage
point increase in the share of labor costs in total production costs is associated with a 1 percentage point decrease in the fraction of sales
declared to the tax authorities. The incidence
of informal payments is lower than might be
expected: just under 10% of firms, on average,
report having been asked for such a payment.

Table 2. Control variables, pairwise correlation coefficients

Exporter (% output)
Foreign ownership
Labor intensity
Fixed assets (%total)
State GDP per capita

(log employees)

(% output)




Source: As above P-values in parentheses.
* denotes significant at 5% level.
denotes significant at 1% level.



Fixed assets
(% total)















Figure 1. Reported tax compliance, percentage of respondents by fraction of sales declared.










mean of taxcompliance
Figure 2. Reported tax compliance, by firm size (number of employees).

This may be because the survey question on
which this analysis is based refers to interactions only with the tax and not other public
authorities, such as health and safety, labor,
or environmental inspectors. 15

(b) Regression analysis
(i) Financial disclosure and sources of finance
The first set of findings from the regression
analysis is that there is also a significant



Table 3. Dependent variables, pairwise correlation coefficients
External audit

Equity finance


Equity finance (%)
Informal finance (%)
Bribe asked (Yes/No)
Influence over policy
(1 = none, 5 = decisive)


Informal finance

Bribe asked



Source: As above P-values in parentheses.
denotes significant at 5% level.
denotes significant at 1% level.



Table 4. Descriptive statistics by firm sector (means)
External audit Equity
Informal Bribe asked Policy
(No = 0,
finance finance (%) (No = 0, influence intensity
Yes = 1)
Yes = 1)
Metals and machinery
Wood and furniture
Auto components








Source: As above.

positive association between a firm’s self-reported degree of tax compliance and its willingness to submit to an external audit. 16 After
calculating marginal effects, the coefficient on
tax compliance in column 2 of Table 5 implies
that the probability of a firm having its accounts audited is 15% higher among fully tax
compliant firms than among non-compliant
firms, holding other explanatory variables constant at their means.17 I also find the expected
association between evasion and firms’ financing decisions, though the effects for both equity
and informal finance are very small. The coefficient on compliance implies that, holding other
factors constant, an increase of 1 percentage
point in the proportion of sales declared is associated with an increase of 0.04 percentage
points in the proportion of the firm’s financing
needs met by equity and a decrease of 0.03 percentage points in the proportion met through
informal sources. The effect is robust to firm
size and to the other control variables discussed

above. Foreign ownership also has a significant
positive—and much larger—effect on equity
financing, as might be expected. But export
profile and labor intensity appear not to matter,
while size has the opposite effect of what one
might expect—larger firms seem to meet a lower proportion of their financing requirements
via equity than smaller ones. This may be due
to ambiguity in the phrasing of the survey question and in particular its failure to distinguish
between equity issued on public markets and
shares sold privately. The phrasing of the survey question may also explain the very low
(0.12), though significant, correlation between
equity finance and the likelihood of a firm’s
having an external audit, as shown in Table 3.
(ii) Relations with government
The second set of findings to emerge from the
regression analysis is that evading firms are
more likely to face demands for informal payments by officials from the tax authorities.


Table 5. Regression results—tax evasion, disclosure, sources of finance and corruption/influence






Tax Compliance

Employees (log)







Foreign ownership
Labor intensity
Percent fixed assets
Per capita income


OLS (1, 3, 4); probit (2, 5); ordered probit (6).
Significant at 5% level;
** Significant at 1% level.
Absolute values of t-statistics in parentheses. Variables are not standardized.

Again, after calculating marginal effects, the
coefficient on tax compliance in column 5 of
Table 5 implies that the probability of a firm
being asked for an informal payment is 9% lower among fully tax compliant firms than among
non-compliant firms, holding other variables
constant at their means. This is consistent with
the second explanation for tax evasion outlined
above—that it persists because of corruption
within the system of tax administration. It is
also robust to the inclusion of the relevant control variables.
As it stands, however, it does not necessarily
mean that firms are paying bribes in order to
avoid being taxed. It might also be that these
firms are targeted by officials because they do
not have legal or other forms of redress. The
survey question in itself does not provide any
information as to whether the relationship between entrepreneur and tax official is collusive
or exploitative. However, the regression analysis also provides us with another finding: firms
that report lower levels of tax compliance also
say they have less influence over regulations
that affect the operation of their business. This
is not conclusive, but it does suggest that the
relationship between officials and under-report-

ing firms is more one of extortion by the latter
than capture by the former.
What have we learnt from this analysis? The
data for manufacturing firms from Brazil show
that tax evasion is a matter of degree and that it
is not limited to small and medium-sized enterprises. Even quite large firms acknowledge concealing around a quarter of their sales from the
tax authorities—assuming that the level of
compliance reported by the firm as typical for
its area of activity corresponds to the level actually practiced by the firm itself. The regression
analysis also illustrates the firm-level economic
costs of tax evasion. Enterprises that are evading taxes are less likely to obtain an external
audit, possibly because they are worried that
disclosure will alert the tax authorities. They
are also somewhat less likely to issue new
shares to finance their working capital and
investment requirements, and more likely to
rely on informal sources of finance such as
moneylenders, though the effects observed in
this dataset are small.


The analysis also shows that manufacturing firms operating in an environment in
which tax evasion is more prevalent are
more likely to suffer demands for bribes
from corrupt officials and are less likely to
have a say in regulations that affect their
business. I interpret this as evidence that
the firms’ decision to evade renders them
vulnerable to blackmail and excludes them
from participation in formal decision-making
institutions. But an alternative explanation,
also consistent with the data, is that evading
firms are engaged in a voluntary transaction
by paying government inspectors to look the
other way. Either way, the results suggest
that the problem is more one of corruption
than identification per se. It is not so much
that tax evasion is impossible to detect,
rather that a dysfunctional system of tax
administration prevents tax laws from being
enforced properly.
These findings do not necessarily mean
that these firms themselves feel constrained


by their lack of access to capital markets.
It is possible, for instance, that the entrepreneurs in question might be quite willing to
forfeit these benefits as a condition of paying less tax, consistent with the voluntarist
view of evasion outlined above. But this
does not imply that such an outcome is
desirable. After all, what is ‘‘voluntary’’ on
the part of the firm—in the sense that it
represents a rational response to economic
circumstances—may not be socially optimal.
There is little payoff from strengthening
minority shareholder protections, for instance, if firms are not going to access capital markets because they are afraid of
alerting the tax authorities to their existence.
Furthermore, if tax evasion has this effect
on capital market participation, it may have
a similar impact on other markets—including those for skills. Indeed, it is likely to
undermine the viability of any arms-length
transaction that is based on disclosure and

1. As the OECD has put it, ‘‘Firms that operate by
hiding all or part of their activities, employment, and
revenues do not grow naturally and hit a ‘‘glass ceiling’’
constraining their development’’ (OECD, 2004, p. 191).
In Turkey, for instance, there is a strong correlation
between firm size, regulatory evasion, and the level of
labor productivity (OECD, 2004, p. 189).
2. A series of industry-level studies by McKinsey &
Company in the late 1990s emphasized the competitive
aspects of relations between compliant and non-compliant entrepreneurs. Because they are outside the law, it is
argued, non tax-compliant firms enjoy a substantial cost
advantage over their competitors. This means they can
afford to be less productive. According to McKinsey, the
gap typically varies from 5–10% of the final product
price to around 40% (McKinsey, 1998, p. 515).
3. According to the Brazilian Institute for Geography
and Statistics (, the share of services in
Brazilian GDP in 2005 was 64%, while that of manufacturing industry—from which the sample analyzed in
this paper was drawn—was 18.4%.
4. According to the Doing Business database, the
average number of procedures required to open a new
business is 7 in high-income countries, 10 in uppermiddle-income countries and 12 in lower-middle-income

countries, and 11 in low-income countries (World Bank,
2004, p. 84). Similar differences exist for other areas of
5. There is a long-standing debate on the implications
of corruption for firm-level efficiency and economic
growth more generally. One view, associated with
Huntington (1968) and others, holds that corruption
can ‘‘grease the wheels of commerce’’ in economies with
inefficient or poorly designed regulation. Under these
circumstances some level of bribery may be optimal,
since it allows more productive firms to buy lower
effective red tape (Lui, 1985). Another view, now
orthodox at the World Bank and other international
financial institutions, is that corruption constitutes a
negative equilibrium which is detrimental to firm
performance and growth. Many scholars in this vein
have argued that low-level public officials may create
regulatory obstacles and generate uncertainty in order to
extort payment from entrepreneurs. For an overview of
the debate and some firm-level evidence see inter alia
Bardhan (1997), Kaufmann and Wei (1999), and Fisman
and Svensson (2000).
6. Of course there are many other reasons why ownerentrepreneurs might not want to tap equity markets,
chief among them that doing so requires ceding control



to outsiders. For a discussion of the issues involved and
the firm-level costs and benefits of participating in public
equity markets see Roell (1996).
7. Interview with Edwyn Neves, Analyst, Advent
Capital, Sao Paulo.
8. ‘‘Firms, companies, etc. usually have two accounts.
Some companies have one very correct one with income,
output, and profit. But, there is another one with the
same information, reported differently. . .. This happens
more in small and medium enterprises, but the big ones
are also experienced in taxes’’ (Brazilian financial
analyst, quoted in Lieberman, 2003, pp. 230–231).
9. For a detailed description of the sample design see
De Farias (2003).
10. There are also empirical grounds for thinking that
the survey responses accurately mirror the respondents’
own experience. De Mel, McKenzie, and Woodruff, for
example, find a very tight correspondence between what
firms reported as typical behavior for enterprises ‘‘similar in all respects’’ and their own behavior, as verified by
the subsequent reports of independent enumerators (De
Mel, McKenzie, and Woodruff, 2007, p. 17). Ramachandran et al. similarly find a high degree of correlation
between data from the World Bank’s Investment
Climate Surveys and independent measures of the
business environment at the country level, even for
potentially sensitive or incriminating questions such as
the tax compliance variable used here (Ramachandran,
Gelb, Shah, & Turner, 2007).
11. It might be that the fiscal authorities deliberately
choose to visit firms they know are under-reporting in
order to extract payment. But this does not appear to be
the case. The relationship between the firm having
received a visit from the tax authorities in the previous

year and its self-reported level of tax compliance is either
weak (0.06 in the case of the state-level authorities) or
statistically insignificant (in the case of the federal and
municipal authorities).
12. As a robustness check, I include sector dummies in
place of the labor intensity and fixed assets variables,
and find that it makes no substantive difference to the
results. The relevant regression output is available from
the author on request.
13. As with the tax compliance variable, it is possible,
though unlikely, that firms deliberately misreported their
levels of employment to the survey enumerators.
14. A simple linear regression of tax compliance on
firm size measured by employees explains less than 3% of
the variance.
15. Response rates to this question were also lower
than for the other variables employed in this analysis,
though this is because around half the firms surveyed
had not received a visit from the tax authorities in the
preceding year, and their responses to subsequent
inquiries about the nature of the interaction were
therefore recorded as missing.
16. Contrary to what one might expect, however,
several firms reported having a public listing but no
external audit. Of the 68 publicly listed firms in the
sample, 49 reported having had their financial statement
reviewed by an external auditor while 19 did not.
17. Since I am using a probit analysis, the parameter
estimates cannot be interpreted in the same way as in a
linear regression. Instead, I calculate marginal effects for
each independent variable, using STATA’s mfx command.

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