We test these assumptions by running the bunching-hole discontinuity regression (Equation 14) on employment, wage bill and capital. Figure A15 plots the average number of employees and wage bill on revenue at each threshold. For each plot we show the linear fit on each side of the thresholds, excluding revenue bins around the thresholds, and display the estimated discontinuity at the thresholds. The wage bill corresponds to 20% of firm’s revenue. Employment slightly drop at the thresholds, though neither coefficients on the discontinuity is significant and the wage bill as a share of revenue remains unchanged. These null results are consistent with no production response, however the standard errors around the coefficients on employment are too large to reject production responses. At the first threshold the discontinuity corresponds to a 1% drop in employment. Given the estimated revenue elasticity and assuming a homothetic production function, production responses should generate a drop in employment three times larger. At the second threshold, we would predict a 1.5% drop in employment, while the discontinuity corresponds to a 2% drop in employment. Note that if firms can manipulate their reported wage bill, the results are biased against uncovering production responses (Almunia and Lopez-Rodriguez 2018).<sup>52</sup> since the increase in the tax rate lowers the incentives to manipulate the wage bill, which could lead to an upward discontinuity. However the corporate tax rate remains below the tax rate on labor everywhere which mitigates this mechanism. Finally, Figure A16 shows that the capital stock value reported on the tax returns is continuous at the thresholds. However the data on capital stock value are noisy and given the confidence intervals we cannot reject a drop in capital at the threshold.

# **7.4 Firm Division and Profit Shifting to Subsidiaries**

Large firms could take advantage of the tax design to create small subsidiaries on which to offload their profits: subsidiaries would report low revenue and high profits, taxed at 10%, while parent firms would report high revenue and low profits, taxed at 30%.<sup>53</sup> We formulate two hypotheses: first, if parent firms incur a cost of opening and administrating subsidiaries, then subsidiaries should disproportionally report revenue just below the thresholds, and the share of subsidiaries should be higher in lower tax brackets. Second, if subsidiaries exist to avoid taxes, then they should display higher profit margins than other firms. We test these hypothesis with a unique dataset of economic affiliates compiled by the Central Bank. Firms are linked by matching shareholders’ names from the corporate ownership registry and direct calls and visits to the firms’ premises.<sup>54</sup> For any pair of

> 52Under collusion between employers and employees, firms should under-report wages instead of over-reporting them, since the sum of the payroll and personal income tax rates is always larger than the corporate tax rate in Costa Rica. The payroll tax rate is 35.67% and the marginal tax rates on personal income taxes are 10 to 15%.

> 53Large firm division and profit shifting could explain both bunching and discontinuities in profits at the thresholds. 54The Central Bank constructed the data of economic groups in 2012, with the goal to obtain accurate information on corporate ownership structure and firm linkages. These data were merged with the corporate tax returns for the years 2008-2012 such that the final dataset (named REVEC) contains firms’ reported revenue and profits.

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