Salary Misreporting and the Role of Firms in Workers’ Responses to Taxes: Evidence from Pakistan
Submitted
This paper exploits employee-employer matched administrative tax data on firms and salaried workers in Pakistan to explore the underappreciated role of firms in determining how workers' taxable earnings respond to taxation. I present evidence on three ways in which firms affect workers' earnings responses. First, third-party reporting of salaries by employers makes underreporting taxable income more costly for workers and reduces evasion of the income tax. Second, firms' equilibrium salary-hours offers respond endogenously to the presence of adjustment costs in the labour market by tailoring offers to aggregate worker preferences. Third, workers learn about the tax schedule from firms' salary offers, making them more responsive to taxation both contemporaneously (by 130%) and in subsequent years (by 100%). However, while third-party reporting makes misreporting more costly, it does not eliminate it in a low tax-capacity setting: 19% of workers still underreport their salaries, leading to a loss of about 5% of tax revenue, and indicating high returns to investments in improving enforcement capacity. The large role played by firms in determining workers' earnings implies that firms need to play a central role in our analysis of income taxation in lower income countries.