Yu-Chun Elisa Cheng, Cornell University

Misreport or Misallocation?  Firms' Behavioral Response to the Size-Dependent Audit Policy in Taiwan

Abstract: This paper examines the impact of size-dependent tax enforcement on firms’ behavior. Specifically, we investigate how firms respond to a policy in Taiwan that lowered the audit probability for firms with annual total revenue below 30 million NTD (approximately 1 million USD). Our study yields three key findings. Firstly, firms strategically bunched below the threshold to avoid higher audit probability, and the magnitude and type of behavioral response varied by industry based on transaction tractability. Downstream sectors, where transactions are hard to track, responded through reporting behavior; while upstream sectors, where transactions are easy to track, responded through production behavior. Secondly, we identify a clear source of misallocation and associated efficiency loss in the manufacturing sector, where almost all transactions are easy to track. Third, we use detailed information on firm-owner-shareholder and their family network to demonstrate that some firms engaged in revenue-shifting to avoid taxes, with suggestive evidence indicating that some even established additional affiliates for this purpose. Overall, our study sheds light on the potential unintended consequences of size-dependent tax enforcement policies.