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Department of Economics pres.

Public Finance: Third-party Audit and Tax Compliance -- Evidence from a Notched Policy in India

Bhanu Gupta, University of Michigan

economics economics

Can resource-constrained tax administrations rely on third-party auditors to increase compliance? We investigate the reaction of firms to a notched policy where they must hire private auditors after crossing a revenue threshold as specified in the Indian tax law. We develop a novel framework to assess the impact of a notched-policy on variables other than the running variable, where static bunching analysis may be biased. Our difference-in-differences estimates suggest that firms remit 15 percent higher taxes and report 12 percent higher taxable income once they are subject to third-party audit. The effect is heterogeneous, with firms reporting higher tax if they generate a substantial paper-trail and have lower labor costs. Finally, extending the policy to smaller firms can result in higher aggregate welfare.

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