Payments Under the Table: Implications for Optimal Taxation

• In Event: Tax Enforcement and Wage Reporting

Abstract

This paper studies optimal income taxation in the presence of wage underreporting—commonly known as payments under the table (PUT)—within formal employment relationships. I develop a model in which heterogeneous firms and workers jointly determine how much of the wage to report formally and how much to hide, subject to audit risk and costs of informality. Firms benefit from avoiding payroll taxes but lose deductibility for hidden wages, while workers evade income taxes but incur stigma costs. This bilateral evasion margin alters both the effective tax incidence and the government’s fiscal returns from labor income. The paper derives a sufficient-statistic optimal tax formula that incorporates both the labor supply elasticity and a new elasticity of PUT with respect to the net-of-tax rate. Crucially, the presence of firms introduces a fiscal wedge between payroll and corporate taxation: PUT reduce payroll tax revenue but raise taxable profits. Whether PUT are harmful or beneficial depends on this wedge and the relative strength of the PUT response. The optimal tax rate is lower when evasion causes net revenue loss, but it may increase when each PUT dollar leads to a net fiscal gain.

Empirically, I calibrate the model to Peru by combining administrative payroll data with household surveys via an optimal transport method to estimate PUT. Then I estimate the PUT elasticity. I find that PUT are prevalent and responsive to tax incentives. The findings suggest that tax policy in economies with weak enforcement and third-party reporting must account for evasion within formal firms, not only informality at the extensive margin. By modeling and measuring this margin, the paper contributes to the design of more effective and equitable tax systems in developing economies.

Author

• Ana Paula Franco, University of Michigan