Tax Reforms in the Presence of Informality in Developing Countries: Incentives to Cheat in Mexico

In this paper we examine incentives to cheat in the Mexican tax system and argue that these are affected by interactions between taxes. We use variation in tax status between Mexican firms and variation in the tax rate between different regions within Mexico to investigate the interaction effects between different taxes that firms face. Firms’ reported profits for one tax, the corporate income tax (CIT), depend on the tax status for its inputs and outputs of another tax, the Value-Added Tax (VAT). In other words, VAT exemptions do not only lead to evasion of VAT; they also lead to greater evasion of the CIT, thereby exacerbating the loss of revenues caused by the exemptions. Juxtaposing results from a dataset from Mexico’s Tax Administration with Economic Census data shows that misreporting to the tax agency is particularly high when tax exemptions are present. We place the results within the broader framework of the tax reform agenda in Mexico that involves decisions affecting states and households in different circumstances as well as investment decisions. These results have implications for other developing countries that have growing informality and tax evasion, as in Pakistan. Short-term fixes, such as amnesties, do not begin to address the underlying incentive difficulties and only serve to make matters worse and should be avoided.