# **7 Mechanisms: Evasion, Avoidance and Production Responses**

## **7.1 Automated Desk Audits**

The tax administration audits comprehensively 300 firms per year, implying that only 0.4% of firms are audited in a given year. Firms are selected with a risk-based analysis, which considers information from third-parties, deviation from industry averages and taxpayers’ history.<sup>45</sup> The tax administration’s limited capacity to conduct comprehensive audits is partially compensated by computer audits, which automatically notify firms of discrepancies between self-reported revenue and revenue estimated from third-party data. Third-party data are collected from credit card sales, POS devices and via the D151 informative tax form which requires firms to declare purchases and sales to other firms (Brockmeyer et al. 2017).<sup>46</sup> Notifications require firms to adjust their revenue to match the amount assessed with third-party data or justify the difference. As of 2015 bunching behavior did not generate a flag.

Figure 7 shows the proportion of firms receiving a notification in 2012 by revenue bins of two million CRC and plots the linear fit excluding revenue intervals around the thresholds.<sup>47</sup> About a third of small firms receive a notification, which highlights that tax declarations are often incomplete and that revenue is frequently under-reported. Compared to their expected probability (from a linear extrapolation) bunching firms are 8.3% more likely to receive a notification at the first threshold and 11.5% at the second threshold. Hence part of bunching appears driven by revenue under-reporting: while bunching firms sometimes get caught for inconsistencies, they appear willing to incur the expected costs.<sup>48</sup> Two other statistics are worth noticing. First, firms reporting revenue just above the thresholds receive slightly fewer notifications, which might indicate that firms in the hole region report revenue more truthfully.<sup>49</sup> Second, the proportion of notifications by revenue is fairly constant on either sides of the threshold, away from the notch, contrarily to the large discontinuity in profit margin, presented in Section 3. This is not inconsistent with our results: the automated system detects revenue under-reporting, while we find that the profits drop past the threshold occurs mainly from cost over-reporting.

A possible explanation for the ease of manipulating costs relative to revenue is that third-party

> 45Figure A13 plots the number of comprehensive audits (Panel a) and percentage of firms audited (Panel b) by broad revenue bins. The SMEs we study have revenue to the left of the figure and are rarely audited: they face a 0.2% probability of being audited. The percentage of audited firms increases with revenue to reach 3% for the largest firms.

> 46A D151 is required anytime two parties transact for 2 million CRC or more in the year ($6,000 in PPP). For commissions, professional fees or rental agreements the reporting threshold is only 50,000 colones ($150)

> 47Note that we did not have access to the underlying micro-data and only received tabulations for 2012.

> 48From discussions with tax administration a non-trivial share of firms do not adjust their tax declaration following a notification. Firms can revise their declarations at minimal cost and do not get systematically prosecuted. However failure to comply increases the risk of a comprehensive audit.

> 49Truthful reporting can explain part of the mass in the hole region only if it is difficult/costly to precisely control revenue by lowering production.

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