Tax Avoidance in Firms

Tax codes can have notches; regions in which after-tax profits are decreasing in before-tax sales. Firms endogenously respond to the notches, leading to bunches in the firm-size distribution. We describe a 1997 policy reform in which the French government implemented a transient tax reform that increased profit taxes by 15% by firms with over 50 million Francs in turnover. We use two complementary approaches to estimate the extent of tax avoidance: from a counterfactual distribution generated from firms far away from the tax notch in the same year, and using the entire pre-tax reform distribution. Both results generate similar results for the extent of tax avoidance. We show that the firms who avoid the tax are the ones with the lowest calibrated adjustment costs and those with the largest incentives (the ones with larger profits). The tax avoidance behavior comes mostly from an increase in inventories.

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