Compliance costs vs. tax incentives: Why do entrepreneurs respond to size-based regulations?

Abstract

This paper studies the mechanisms behind the responses of entrepreneurs to size-dependent tax regulation. We exploit the value-added tax (VAT) exemption threshold in Finland. Both tax incentives (remitted VAT) and compliance costs (frequent filing of VAT reports, understanding the VAT system, etc.) change at this sales-based threshold in a discontinuous manner. We utilize variation in both the VAT rate and reporting requirements to show that the large observed sales response is caused by the compliance costs of VAT rather than the level of the VAT rate, highlighting the key role of compliance costs among small firms and entrepreneurs.