Notch and Catch: Dynamic Inefficiency in the Corporate Income Tax Schedule

• In Event: Efficiency and Distortions in the Corporate Tax

Abstract

Notched corporate income tax schedules are prevalent worldwide, yet their effects on dynamic allocative efficiency remain understudied. Leveraging detailed administrative employer-employee linked tax return data from Taiwan, alongside a significant reform shifting the exemption threshold, we analyze the dynamic consequences of corporate tax notches. We document substantial bunching in the corporate income distribution, as firms strategically respond by reducing real output and shifting profits toward labor salaries to position themselves just below the threshold. Moreover, we identify a "notch trap": firms that bunch below the exemption threshold become persistently constrained, experiencing 20% lower average revenue growth and an 8.1% higher exit rate relative to firms just above the threshold.
To analyze these dynamics, we build an industry dynamics model capturing both static decisions (production levels, tax reporting) and dynamic choices (capital adjustment, market exit). Firms strategically avoid taxes by adjusting production or misreporting salaries. Conditional on their bunching decisions, firms subsequently determine whether to exit or continue operations, as well as their optimal investment. Estimating this structural model enables us to quantify efficiency losses induced by notched corporate tax schedules and explore optimal tax policy design. We plan to evaluate dynamic allocative efficiency under varying notch scenarios, thereby informing tax policies that balance revenue generation and market efficiency.

Authors

• Luming Chen, University of Michigan

• Yu-Chun Cheng, Cornell University

• Tzu-Ting Yang