reporting revenue at the thresholds, while firms with sufficiently large costs (e.g. zero profits) have no incentives to change their revenue. Second, for firms further up the revenue distribution and hence infra-marginal to the bunching behavior, changes in the tax rates create higher incentives to lower revenue and to increase costs.

In administrative corporate tax returns we observe clear excess mass in the revenue distribution just below the thresholds and missing mass above them. We use the estimated counterfactual change in revenue of the marginal bunching firm to measure the elasticity of revenue with respect to the net of tax rate, following the notch estimation of Kleven and Waseem (2013). More importantly, we find that firms reporting revenue above the thresholds respond to higher tax rates by sharply reducing their reported profits. This is evidenced by a large “donut-hole” discontinuity in average profits by revenue on each side of the thresholds, including for firms _infra-marginal_ to the bunching behavior. The profit response is a mix of firms reducing their revenue and increasing their costs when faced with higher tax rates. Using the revenue elasticity, estimated in the first step, we hold revenue responses constant, such that the remaining profit discontinuity only identifies changes in reported costs. By combining the revenue and cost responses we estimate the elasticity of profits with respect to the net of tax rate. The resulting elasticities are very large: 5 at the first threshold and 3 at the second threshold, an order of magnitude higher than estimates for small firms in OECD countries (Devereux, Liu and Loretz 2014, Patel, Seegert and Smith 2015).

This estimation procedure provides a robust measure of the elasticity of profits. Intuitively, the elasticity of profits is identified from the “donut-hole” discontinuity in profits around the threshold, while bunching is used to separate the revenue and cost elasticities. In contrast, the revenue and cost elasticities separation suffers from two limitations: it abstracts from selection into bunching as a function of costs and it only estimates the revenue response of the marginal bunching firm.<sup>1</sup> Under heterogeneity in revenue elasticities, this corresponds to the highest elasticity firm and provides an upper (lower) bound to the average revenue (cost) elasticity. To address these limitations we model selection into bunching as a function of firms’ costs by assuming a counterfactual for the revenue and cost distribution. We then simultaneously estimate the revenue and cost elasticities to match the two key moments: (1) the excess mass at the threshold, (2) the donut-hole discontinuity in costs.<sup>2</sup> We find that costs are much more elastic than revenue to changes in the tax rate, and account for over two-thirds of the drop in reported profits.<sup>3</sup> We perform several robustness tests to support these results. First, the “donut-hole” disconti-

> 1The bunching estimation measures the counterfactual revenue of the marginal buncher in order to satisfy the constraint that the bunching mass below the notch equals the missing mass above it. 2We also estimate the share of firms with large adjustment frictions as the share of firms located above the threshold which face a marginal tax rate above one.

> 3The large elasticity of costs rationalizes the frequent use of tax policies determined by revenue instead of profits in developing countries. Examples include registration thresholds, large taxpayers units, and corporate tax systems with different rates as a function of revenue such as Costa Rica’s, which exist in over 30 countries (KPMG tax guides).

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