Taxpaying Response of Small Firms to an Increased Probability of Audit : Some Evidence from Italy

Income tax evasion by small firms has been seldom investigated mostly because of lack of data. In this paper we use a large data set produced by the Italian Revenue Agency for this project to analyse a recent policy to contrast business income tax evasion. Since 1998 Italy has adopted a method to audit small businesses (Studi di Settore), which defines the probability of a tax audit based on presumptive and reported levels of sales. In 2007 a letter campaign was implemented by the Italian Revenue Agency aimed at reducing manipulation of reports by threatening that if the "anomaly" was repeated with the 2008 tax declaration, the probability of a thorough tax audit would have drastically increased. By using difference in difference with matching methods on a sample of about 50,000 treated firms and 95,000 controls, we find that the letter campaign had a positive and statistically significant average effect on treated firms. A cost-benefit analysis of the policy suggests that the letter campaign generated a net increase of revenues of about 140 million euros