# **1 Introduction**

Lower-income countries only collect 20% of their GDP in taxes, compared to 35% on average for OECD countries (Gordon and Li 2009, Besley and Persson 2013). For the corporate income tax, the slope of tax-take on GDP is similar: low-income countries collect 2% of their national income, while rich countries collect 3.5%. A plausible explanation for this pattern is that the elasticity of corporate profits with respect to the tax rate is larger in developing countries due to tax evasion. Since the corporate tax typically allows for all production costs to be deducted, firms could reduce their tax base by over-reporting costs (Slemrod, Collins, Hoopes, Reck and Sebastiani 2015, Carrillo, Pomeranz and Singhal 2017). Some countries address this challenge by applying a lower rate to a broader base, with limited deductions, thereby reducing evasion incentives. However this introduces distortions to firms’ optimal scale and violates production efficiency (Diamond and Mirrlees 1971). Best, Brockmeyer, Kleven, Spinnewijn and Waseem (2015) model this revenue versus production efficiency trade-off and empirically find that a broader corporate tax base is desirable in Pakistan. However, their variation mixes firms’ revenue and profits responses, which prevents them from separately estimating these key elasticities. The elasticity of profits is required to measure the revenue maximizing rate under a profit tax, and both the revenue and profit elasticities are needed to jointly estimate the optimal rate and base.

We take advantage of Costa Rica’s corporate tax design and rich administrative data to make three contributions. First, we estimate the elasticity of profits with respect to the tax rate for small firms: we find large elasticities (3-5), which severely constrain the revenue collection of profit taxes. Second, we separately estimate the elasticities of revenue and costs and show that two-thirds of firms’ responses to higher tax rates are explained by increases in reported costs. Using these elasticities we simulate the optimal tax system and find that broadening the base while lowering the rate generates tax revenue gains of up to 80%, keeping profits constant. Third, using additional data sources we show that the revenue elasticity is driven by tax evasion, with limited evidence of production responses, which reinforces the recommendation of a broader base with a lower rate.

While corporate tax systems often tax profits at a flat rate, Costa Rica imposes increasing _average_ tax rates on profits as a function of firms’ revenue. The determinant of the tax rate (revenue) is different from the tax base (profits). This generates a notched tax schedule: firms’ average tax rate jumps from 10 to 20% at the first revenue threshold and from 20 to 30% at the second threshold. Theoretically, the changes in average tax rates above the thresholds should induce two types of behavioral responses. First, firms which would have reported revenue slightly above the thresholds, absent the rate increase, have a strong incentive to reduce their revenue to just below the thresholds (bunching), which lowers the average tax rate they face on their entire profits. Moreover, firms should select into bunching as a function of their costs: firms with low costs gain the most by 1