Tax law changes, income-shifting and measured wage inequality: Evidence from India

We examine the effects of a 1992 income tax law change in India that eliminated the tax penalty on wages paid to partners in partnership firms using a large dataset covering all registered plants in the manufacturing sector over the period 1986 to 1995. This tax law change provides a unique opportunity to identify the effects of tax policy changes on firm behavior in a developing country context. We find an immediate and pervasive response by partnership firms to the tax law change, reflected in a significant shifting of income from profits to managerial wages. Because about 50% of registered manufacturing plants operate in the form of partnerships (including most family-run businesses). income-shifting by these firms could have a significant impact on measured wage inequality. We find a sizeable jump in the mean and median relative wage of skilled workers (which includes managers and partners) following the tax law change in 1992. Although this sudden increase in measured wage inequality follows major trade liberalization and deregulation reforms announced earlier (in July 1991), we find that the income-shifting induced by the tax law change explains almost all of the observed increase in measured wage inequality following these reforms. This finding is robust to inclusion of controls for a number of other potential sources of post-liberalization increases in wage inequality. Our results show that firms respond strongly to tax incentives for income-shifting, and highlight the need to control for the potential effects of tax incentives in studies of wage inequality. Because wages received by partners were reported as business income on tax returns, the finding of an increasing share of top wage earners in total wages in India in the 1990s, documented by Banerjee and Piketty [Banerjee, Abhijit, and Thomas Piketty. 2005. "Top Indian Incomes, 1922-2000." The World Bank Economic Review 19 (1): 1-20.] using tax return data, is unlikely to be much affected by the tax reform we analyze here. (C) 2008 Elsevier B.V. All rights reserved.