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Abstract:
In standard tax-compliance models, tax withholding at source is irrelevant. In these models, tax compliance is determined by a combination of enforcement (via audits and penalties), social motives, and third-party reporting, which deters evasion by enabling the tax authority to verify self-reported liability. The fact that third parties may also withhold taxes at source – and the impact of withholding on compliance – has largely been ignored. Yet tax withholding is common around the world: withholding of the personal income tax by employers is almost universal, and withholding is also applied to firms, especially in low-income countries. We provide a simple framework to rationalize the use of tax withholding as a compliance mechanism and test its predictions using administrative data from Costa Rica. We find that doubling the tax withholding rate applied by credit-card companies increases sales tax remittance among treated firms by 39% and aggregate sales tax revenue by 8%, even though the statutory tax rate and third-party reporting requirements remain unchanged. The mechanisms are a default payment effect and a change in enforcement perceptions. Our findings contribute to a broader debate about the determinants of fiscal capacity among countries at different levels of economic development.

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