Targeting in Tax Behavior: Evidence from Rwandan Firms
The tax behavior of small firms in low income countries shapes government revenues and the welfare of poor entrepreneurs. This paper provides evidence that how these firms respond to tax instruments diverges from traditional models of compliance in ways that have unintended and regressive consequences. Using the universe of administrative filings in Rwanda, I document perverse responses to changes in liability: an income tax reform that standard models would predict should lead all taxpayers to pay lower taxes in fact caused firms to increase tax paid by 75%. To explain this behavior, I establish a new stylized fact: firms consistently target past liability when paying taxes, even when the structure of liability changes. Many firms bunch sharply on their previous amount of tax paid year after year and stick to this level despite changes in their tax rate. Others increase tax paid rather than deviating downward from past levels when changes to the tax schedule remove their ability to pay the same amount as before. Evidence from a survey of filers and a randomized information experiment imply that firms’ uncertainty about own earnings generates reliance on the heuristic of previous liability, while enforcement perceptions and peers influence how firms select target amounts. Ultimately, this behavior produces regressive outcomes: less educated and less profitable entrepreneurs are more likely to overpay relative to their true liability.