Are Politically Connected Firms More Likely to Evade Taxes? Evidence from Tunisia Downloaded from https://academic.oup.com/wber/article-abstract/30/Supplement_1/S166/2897413 by LEGVP Law Library user on 08 August 2019 Bob Rijkers, Hassen Arouri, and Leila Baghdadi Are politically connected firms more likely to evade taxes? Using tax, social security, and customs records from Tunisia in which firms owned by former president Ben Ali and his family are identified, this paper demonstrates that connected firms were more likely to evade taxes. Ceteris paribus, connected firms are 4.6% more likely not to submit a tax declaration in spite of registering workers and/or customs transactions and 8.4% more likely to report anomalously low sales when submitting a tax declaration. JEL Codes: H26, D22, E26 Are politically connected firms more likely to evade taxation? The jury is out, in spite of the prevalence of political connections (Faccio 2006) and their associa- tion with anticompetitive practices (Claessens et al. 2008; Faccio et al. 2006; Mitten and Johnson 2003; Rijkers et al. 2014b). The question is especially rele- vant for developing countries, since lackluster revenue mobilization (Slemrod and Yithzaki 2002) and problematic state-business relationships are both symp- toms and causes of underdevelopment. Taking advantage of unique administrative and tax data from Tunisia in which firms with ownership connections to former president Ben Ali confiscated Bob Rijkers (corresponding author) is an economist at The World Bank; his e-mail address is brijkers@ worldbank.org; Hassen Arouri is a chief engineer and director of the business register and economic surveys at the Institut National de la Statistique Tunisienne, Tunis Business School; Leila Baghdadi is an associate professor of economics at the University of Tunis, Tunisia and World Trade Organization Chair Holder, Tunis Business School, University of Tunis. Disclaimer: The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations or those of the Executive Directors of the World Bank or the governments they represent. Acknowledgments: We would like to thank Rebekka Grun, Melise Jaud and especially Antonio Nucifora for help obtaining access to the data, and Caroline Freund and Gael Raballand for useful discussions. Vincent Belinga, Najy Benhassine, Anne Brockmeyer, Marie-Francoise Marie Nelly, Woubet Kassa, Alessia Luo, Natsuko Obayashi, Abdoulaye Sy, and the Tunisian tax authorities provided useful comments. We are very grateful to the Tunisian Institut National de la Statistique for generously hosting us, helping assemble the database, and providing incisive feedback. Research for this paper has been supported in part by the governments of Norway, Sweden, and the United Kingdom through the Multidonor Trust Fund for Trade and Development and by the UK Department for International Development (DFID) through the Strategic Partnership on Economic Development. THE WORLD BANK ECONOMIC REVIEW, VOL. 30, SUPPLEMENT pp. S166– S175 doi:10.1093/wber/lhw018 Advance Access Publication June 9, 2016 # The Author 2016. Published by Oxford University Press on behalf of the International Bank for Reconstruction and Development / THE WORLD BANK. All rights reserved. For permissions, please e-mail: journals.permissions@oup.com. S166 Rijkers, Arouri, and Baghdadi S167 in the aftermath of the Jasmin Revolution are identified, this paper answers this question by assessing whether connected firms were more likely to either (i) not declare or (ii) underreport their earnings to the tax authorities. Downloaded from https://academic.oup.com/wber/article-abstract/30/Supplement_1/S166/2897413 by LEGVP Law Library user on 08 August 2019 Tunisia, a small Northern African country at the forefront of the Arab Spring, provides an interesting context to examine this issue. The Ben Ali family had exten- sive business interests, owning, fully or in part, at least 662 firms, which together accounted for approximately 5% of private sector output. With a revenue to GDP ratio of 21%, its revenue collection performance is not atypical of a country at its stage of development. Findings for Tunisia are thus likely to be relevant for other middle-income and developing countries. Moreover, Tunisia has a wealth of administrative data, but information sharing between (and within) different government agencies was extremely limited during the Ben Ali era. This in turn facilitates testing for tax evasion through an examina- tion of discrepancies between different administrative databases. More specifically, triangulating social security and customs data with tax data enables us to assess whether firms that reported hiring workers and/or customs transactions submitted a tax declaration and, if so, whether the earnings reported in these declarations are likely to be credible. This simple but powerful strategy of testing for tax evasion can easily be replicated in other countries. Previewing our main findings, tax evasion is rife in Tunisia; 9% of firms do not submit a tax declaration in spite of reporting hiring workers to the social security administration and/or participating in international trade. Amongst those that submit declarations, 15% report anomalously low sales. Connected firms are among the worst evaders, being ceteris paribus 5% more likely not to declare taxes and 8% more likely to report anomalously low levels of output when sub- mitting tax declarations. These results contribute to the literature on political connections by highlighting tax evasion as a mechanism by which connected firms reap rents. Estimates of the premium on being connected that do not consider such evasion, which is the norm in the literature, are likely to be downward biased. The findings furthermore add to the literature on the determinants of tax compliance. Our findings also resonate with a companion study in which we demonstrate that connected firms were more likely to evade tariffs by underreporting prices (Rijkers et al. 2015). I. HYPOTHESES Why might politically connected firms be more likely to evade taxes? Models of tax evasion predict it to be a function of rewards, the risk of being caught, and penalties conditional on being caught (see Alm 1999, Andreoni et al. 1998, Slemrod 2007, and Slemrod and Yithzaki 2002, for reviews of the literature). These factors may vary between connected and nonconnected firms. The Ben Ali family was notorious both for being above the law and for abusing it for personal purposes (Government of Tunisia 2011). Officials might have been more willing to tolerate evasion by connected firms because of career concerns, to ingratiate S168 THE WORLD BANK ECONOMIC REVIEW themselves with the ruling elite, or because of fear of reprisals.1 Alternatively, po- litically connected firms may have been less risk averse because their owners were wealthier or better capable of coping with the consequences of being caught. Downloaded from https://academic.oup.com/wber/article-abstract/30/Supplement_1/S166/2897413 by LEGVP Law Library user on 08 August 2019 However, being associated with corrupt behavior could constitute a more severe reputational risk for connected entrepreneurs with political exposure than for nonconnected entrepreneurs. Connected firms seem to have had better access to information and thus might have been better able to anticipate controls and to judge where and when evasion was more likely to remain undetected. While distinguishing between these different channels is beyond the scope of this note, they form the basis for the null hypothesis that connected firms are more likely to evade taxes. Moreover, one may expect potential differences between con- nected and nonconnected firms to vary with the strength of connections. I I . D ATA Identifying political connections: In the aftermath of the Jasmin revolution, the Tunisian government ordained by presidential decree (Decret-Loi 2011–13) the confiscation of the assets of 114 individuals belonging to the Ben Ali clan, includ- ing Ben Ali himself, his relatives, and his in-laws. The list almost exclusively com- prises family members, which helps assuage endogeneity concerns, since only a handful of entrepreneurs managed to select into the family through marriage. The confiscation process is still ongoing. Amongst the assets confiscated thus far are boats, yachts, houses, bank accounts, and 662 firms, which we use to identify firms as politically connected. Of these, there were 261 firms for which listed in- dividuals had 100% ownership. These are referred to as “Fully Ben Ali owned.” Another 226 firms were co-owned by the Ben Ali clan and nonlisted individuals. Such firms are referred to as “Partially Ben Ali owned.” For another 175 firms, the exact ownership share of the Ben Ali family could not be determined on the basis of the information provided to us.2 Such firms are referred to as having “Unknown Ben Ali Ownership shares.” This variation in the extent of Ben Ali ownership is used as a proxy for the strength of political connections.3 Administrative data: To assess whether connected firms are more likely to evade taxes, we examine the prevalence of discrepancies between different ad- ministrative databases, notably tax records, social security records, and firm-level 1. During interviews Tunisian officials mentioned that speaking up against the Ben Ali family was a precarious proposition. In other countries, officials may have stronger incentives not to tolerate corrupt behavior by politically connected individuals since there is more media scrutiny of such individuals and thus a higher propensity of complicit behavior being detected (Slemrod 2007). 2. www.infojort.com 3. One limitation is that we only identify these firms as being connected in 2011; thus, there might have been some firms that were connected in the period 2006–2009 but that exited before 2011 that we do not identify. We also do not identify firms that benefitted from indirect connections with the president and his family. As such, our results are likely to underestimate the prevalence of political connections. Rijkers, Arouri, and Baghdadi S169 customs transactions data.4 This comparison is useful, since interaction and data sharing both between and within different government agencies was minimal— and entrepreneurs were aware of this. Only after the Revolution were we able to Downloaded from https://academic.oup.com/wber/article-abstract/30/Supplement_1/S166/2897413 by LEGVP Law Library user on 08 August 2019 assemble this dataset with the help of the Tunisian authorities, the Tunisian Institute National de la Statistique, and the World Bank. In addition, social secur- ity and customs data provide useful objective indicators of economic activity and the quality of social security data is high.5 The database we assemble covers all registered private sector firms in Tunisia, including the self-employed. We exclude firms in the regime forfaitaire, for whom controls are limited (typically these are very small firms with sales up to 100.000 TND), and focus exclusively on private firms. Firms in the agricultural and hydrocarbon sectors are also excluded since they face different reporting re- quirements. We focus on the period 2006 – 2009 since for this period the richest set of firm characteristics is available.6 Because of these sample restrictions, we have a total of 432 connected firms, of which 192 are fully Ben Ali owned, 147 are partially Ben Ali owned, and 93 have unknown degrees of Ben Ali owner- ship. Descriptive statistics for the estimation sample are presented in appendix table A1. I I I . N O N R E PO R T I N G : M I S S I N G TA X D E C L A R AT I O N S To start with, we test whether connected firms are less likely to submit tax decla- rations conditional on being active, that is, reporting (i) hiring workers to the social security administration and/or (ii) having customs declarations on import- ing and/or exporting. Second, we examine the prevalence of reporting anoma- lously low levels of sales, defined as declarations in which sales reported to the tax authorities are lower than at least one of the following (i) the wage bill re- ported to the social security administration (ii) total exports or (iii) total imports recorded in customs transactions data. Entering and exiting firms are excluded from the analysis, since discrepancies in the declarations of such firms may be due to starting up and filing of bankruptcy. 4. Social security data were obtained from the Caisse Nationale de la Se ´ Sociale (CNSS), ´ curite customs transactions records were obtained from La Direction Ge ´ rale des Douanes and tax records were ´ ne obtained from La Direction Ge ´ rale des Impo ´ ne ˆ ts (D.G.I.). 5. Comparing employment rates calculated on the basis of administrative data with employment rates based on labor force surveys suggests informality in the form of nonregistered employment is limited, typically amounting to less than 10% of employment except for in the construction sector (Rijkers et al. 2014a). Social security records are thus a relatively reliable indicator of activity. Similarly, export data also provide a useful benchmark, since firms have limited incentives to underreport exports as these are typically not taxed. Import data are more problematic, since firms have strong incentives to under or misreport imports to evade taxes. 6. Information on import transactions is not available in 2010, while information on foreign ownership shares and tax regime is not available prior to 2006. However, the main results presented in this paper also obtain in 2010 as well as during the period 2001–2006; these results are not presented here in order to conserve space but are available upon request. S170 THE WORLD BANK ECONOMIC REVIEW T A B L E 1 . Missing Tax Declarations Missing Tax Declarations Downloaded from https://academic.oup.com/wber/article-abstract/30/Supplement_1/S166/2897413 by LEGVP Law Library user on 08 August 2019 Dependent variable: Tax declaration is missing Sample: firms which submitted social security and/or customs declarations 1 2 3 Ben Ali firm 0.019 0.046*** (0.018) (0.018) Partially Ben Ali owned 0.044 (0.029) Unknown Ben Ali % 0.010 (0.033) Fully Ben Ali owned 0.064** (0.027) Mean dep var non-Ben Ali firms 0.090 0.090 0.090 Year (4) Yes Yes Yes Firm controls (6) Yes Yes Governorate (24) Yes Yes Industry (580) Yes Yes N 241,839 241,839 241,839 # Firms 80,199 80,199 80,199 Adjusted R2 0.001 0.180 0.180 *, **, and *** denote results are statistically significant at the 10%, 5%, and 1% level respec- tively. Standard errors are clustered by firm. The sample comprises all registered private sector in- cumbent firms that are not in the regime forfaitaire and that recorded hiring works or paying wages to the social security administration and/or recorded customs transactions, with the exception of en- trants and exiting firms and firms in the agricultural and hydrocarbon sectors. Firm controls include; dummies for foreign ownership and being in the offshore sector, log age, log(L þ 1), log(Exports þ 1), and Log(Imports þ 1), where missing values are assigned zeros. Sample period: 2006– 2009. Estimated using Ordinary Least Squares. Results of OLS regressions7 are presented in table 1 in which the dependent var- iable is an indicator of whether a firm has a missing tax declaration despite being active, that is, recording having hired and/or paid workers to the social security ad- ministration and/or recorded customs transactions. The first thing to note is that tax evasion is widespread; 9.0% of nonconnected firms did not submit a tax declaration despite being economically active (see the bottom row).8 One might wonder why firms would report hiring workers and/or customs transactions but 7. We present OLS results for ease of interpretation and computational feasibility (we are including a large number of fixed effects). 8. Of course firms have the option of not reporting to any administrative authority, in which case we consider them “inactive.” Of firms contained in the Tunisian National Business Register, the Repertoire National des Entreprises, 23% of firms are inactive, while 14% of connected firms are inactive. The high prevalence of inactive firms is due to a combination of temporary exits, which are strongly concentrated amongst the self-employed (i.e., one-person enterprises), evasion, and the presence of zombie firms; firms that are no longer economically active but have not legally ceased to exit. Since Ben Ali firms tend to be larger, it is perhaps not surprising that they are less likely to be inactive (in addition, identification of connections occurs in 2011, while our sample starts in 2006). Rijkers, Arouri, and Baghdadi S171 not submit a tax declaration. A possible explanation is that being registered with the social security administration entitles employees to various benefits, including health insurance, while engaging in international trade without going through Downloaded from https://academic.oup.com/wber/article-abstract/30/Supplement_1/S166/2897413 by LEGVP Law Library user on 08 August 2019 customs is arguably difficult (though smuggling does happen). Second, such evasion is even more widespread among active connected firms. The estimates presented in column 1, which control for being connected and year dummies only, suggest that connected firms are 1.9% more likely than noncon- nected firms not to submit a declaration, but the differential with nonconnected firms is not statistically significant. Once their industry, location, and superior size and trade performance are controlled for, as is done in column 2, the evasion premium on being connected rises to 4.6% percentage points and becomes sig- nificant at the 1% level. To assess whether the evasion propensity varies with the strength of political connections, columns 3 replicates the second specification 2, but now separates Ben Ali firms into those that are (i) known to be owned only in part by the Ben Ali family (ii) firms which are fully Ben Ali owned and (iii) a residual group for which the exact Ben Ali ownership share is not known. While coefficient esti- mates are positive for all three groups, they are only significant for the group of fully Ben Ali owned firms, for whom the connectedness premium is highest; ceteris paribus they are 6.4% more likely not to submit any tax declarations than nonconnected firms. I V. U N D E R R E P O R T I N G We now turn to examining the prevalence of underreporting amongst those firms that submitted tax declarations and reported hiring workers and/or customs transactions, by examining the incidence of anomalously low levels of sales defined here as sales that are lower than either the wage bill, total imports, or total exports.9 Table 2 presents results using specifications that mirror those presented in table 1 but using as dependent variable having submitted an anomalous declaration. Such anomalous declarations are prevalent; no less than 15.3% of nonconnected firms submit a tax declaration in which they claim their sales were lower than their wagebill, total exports, or total imports. Amongst Ben Ali firms submitting tax declarations, this percentage is an additional 6.6% higher (column 1), and the dif- ferential with nonconnected firms is statistically significant. Controlling for other firm characteristics, such as industry, location, age, size, exports, and imports, con- nected firms are 8.4% more likely to submit an anomalous declaration (column 2). Differentiating by type of connection, as is done in column 3, demonstrates that 9. There are a number of firms for which reported sales are 0. We exclude these from the analysis of underreporting since we are concerned these might reflect temporary cessation of economic activity and/or data entry errors. Our results, which are omitted to conserve space but available upon request, become even stronger when we include them. S172 THE WORLD BANK ECONOMIC REVIEW T A B L E 2 . Underreporting (Anomalous Declarations) Underreporting Downloaded from https://academic.oup.com/wber/article-abstract/30/Supplement_1/S166/2897413 by LEGVP Law Library user on 08 August 2019 Dependent variable: Reported sales are anomalously low(Sales , Wagebill and/or Sales , Exports and/or Sales , Imports) Sample: firms that submitted (i) a tax declaration and (ii) either a social security or customs declaration or both 1 2 3 Ben Ali firm 0.066*** 0.084*** (0.023) (0.022) Partially Ben Ali owned 0.047 (0.031) Unknown Ben Ali % 0.065 (0.047) Fully Ben Ali owned 0.119*** (0.035) Mean dep var non-Ben Ali firms 0.153 0.153 0.153 Year (4) Yes Yes Yes Firm controls Yes Yes Governorate (24) Yes Yes Industry (580) Yes Yes N 212,900 212,900 212,900 # Firms 70,737 70,737 70,737 Adjusted R2 0.009 0.217 0.217 *, **, and *** denote results are statistically significant at the 10%, 5%, and 1% level respec- tively. Standard errors are clustered by firm. The sample comprises all registered private sector in- cumbent firms reporting positive turnover that are not in the regime forfaitaire and that recorded hiring workers and/or paying wages to the social security administration and/or recorded customs transactions, with the exception firms in the agricultural and hydrocarbon sectors; entrants and exiting firms are not included. Firm controls include; dummies for foreign ownership and being in the offshore sector, log age, log(L þ 1), log(Exports þ 1), and Log(Imports þ 1), where missing values are assigned zeros. Sample period: 2006– 2009. Estimated using Ordinary Least Squares. fully Ben Ali owned firms are most likely to submit anomalous declarations – in spite of being least likely to submit tax declarations in the first place. Note that an anomalous declaration does not constitute proof of tax evasion by itself; it may reflect poor management, measurement error, and/or time lags in the production or sales process. Table A2 in the appendix presents robustness checks that demonstrate that the results also obtain when focusing on profit making firms only (columns 1 and 2). Moreover, they are robust to using more stringent definitions of anomalous declarations, which allow for lags between the production and sales processes, notably (ii) defining a declaration to be ano- malous if cumulative output over a two year period is lower than either the wage- bill, exports, or imports in the base year (columns 3 and 4) and (iii) average output between 2006 and 2009 is lower than either the average wagebill, average imports, or average exports over the same period (columns 5 and 6). Using either of these alternative measures, connected firms are consistently significantly more likely to report anomalously low levels of sales. Rijkers, Arouri, and Baghdadi S173 V. C O N C L U S I O N By examining discrepancies between administrative data from Tunisia that were Downloaded from https://academic.oup.com/wber/article-abstract/30/Supplement_1/S166/2897413 by LEGVP Law Library user on 08 August 2019 curated without coordination between different government agencies, this paper unveils widespread tax evasion; 9% of firms do not submit a tax declaration in spite of registering workers, and 15% report earnings which are anomalously low compared to declarations made to other government agencies. Firms owned by the Ben Ali family were among the worst perpetrators, being ceteris paribus both 5% less likely to submit tax declarations and 8% more likely to underreport earnings to the tax authorities. Fully Ben Ali owned firms have the highest evasion propensity. Overall, our findings not only attest to tax evasion being a mechanism by which connected entrepreneurs reap rents (see also the companion paper, Rijkers et al. 2015, which demonstrates that connected firms were more likely to evade tariffs) but also suggest that estimates of the impact of political connections on firm perfor- mance that do not consider such evasion are likely biased downwards. While the methods used in this paper are simple, they are powerful and can easily be replicat- ed in other countries where information sharing across institutions is imperfect. A P P E N D I X TA B L E S T A B L E A 1 . Descriptive Statistics Summary statistics Connected firms Nonconnected firms Mean Std.Dev. Obs Mean Std. dev. Obs Missing tax declaration 0.109 0.312 813 0.090 0.286 241,026 Anomalous declaration* 0.219 0.414 718 0.153 0.360 212,182* Foreign 0.034 0.182 813 0.039 0.193 241,026 Offshore 0.100 0.300 813 0.083 0.275 241,026 Log age 2.130 0.736 813 2.417 0.722 241,026 Log (L þ 1) 2.268 1.789 813 1.440 1.164 241,026 Log (Exports þ 1) 2.577 5.087 813 1.106 3.583 241,026 Log (Imports þ 1) 6.322 6.796 813 2.089 4.620 241,026 Note: The sample comprises all registered private sector incumbent firms reporting positive turn- over that are not in the regime forfaitaire and that recorded hiring workers and/or paying wages to the social security administration and/or recorded customs transactions, with the exception firms in the agricultural and hydrocarbon sectors; entrants and exiting firms are not included. Sample period: 2006– 2009. * A tax declaration is considered anomalous if sales reported to the tax authorities are strictly lower than the wage bill reported to the social security administration and/or imports and/or exports recorded by customs. Firms that report their sales to be 0 are not included in our analysis of anomalous declarations. T A B L E A 2 . Alternative Definitions of Anomalously Low Output Underreporting—Alternative definitions Dependent variable: Reported sales are anomalously low S174 Only firms reporting positive profits Using a two-year window 4 Year averagees Definition of anomalously low output Sales , Wagebill and/or Sales t þ Sales tþ1 , Wagebillt Y  , Wagebill and/or Sales , Exports and/or and/or Sales t þ Sales  , Exports and/or Y Sales , Imports) tþ1 , Exportst and/or Sales t þ Y  , Imports Salestþ1 , Importst Sample restriction Only firms reporting positive Firms that report output in Only firms that are active output two consecutive years 4 consecutive years 1 2 3 4 5 6 Ben Ali firm 0.066*** 0.063*** 0.060** (0.025) (0.021) (0.029) Partially Ben Ali owned 0.052 0.017 0.076* (0.040) (0.026) (0.046) THE WORLD BANK ECONOMIC REVIEW Unknown Ben Ali % 0.040 0.045 0.029 (0.046) (0.050) (0.061) Fully Ben Ali owned 0.095** 0.104*** 0.067 (0.043) (0.035) (0.045) Mean dep var non-Ben Ali firms 0.091 0.091 0.099 0.099 0.082 0.082 Year (4) Yes Yes Yes Yes Yes Yes Firm controls Yes Yes Yes Yes Yes Yes Governorate (24) Yes Yes Yes Yes Yes Yes Industry (580) Yes Yes Yes Yes Yes Yes N 130 690 130 690 148 713 148 713 41280 41 280 # firms 56 679 56 679 60 686 60 686 41 280 41 280 Adjusted R2 0.216 0.216 0.193 0.193 0.240 0.240 *, **, and *** denote results are statistically significant at the 10%, 5%, and 1% level respectively. Standard errors are clustered by firm. Subject to the specific sample restrictions listed in the table heading above, the sample comprises all registered private sector incumbent firms reporting positive turnover that are not in the regime forfaitaire and that recorded hiring workers and/or paying wages to the social security administration and/or recorded customs transactions, with the exception firms in the agricultural and hydrocarbon sectors; entrants and exiting firms are not included. Firm controls include; dummies for foreign ownership and being in the offshore sector, log age, log(L þ 1), log(Exports þ 1), and Log(Imports þ 1), where missing values are assigned zeros. Sample period: 2006– 2009. Estimated using Ordinary Least Squares. Downloaded from https://academic.oup.com/wber/article-abstract/30/Supplement_1/S166/2897413 by LEGVP Law Library user on 08 August 2019 Rijkers, Arouri, and Baghdadi S175 REFERENCES Alm, J. 1999. “Tax Compliance and Administration.” In W. 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