Recently several developing and transitional countries changed their personal income tax from fairly progressive to flat in an effort to improve efficiency.
But how do taxes affect incentives when people can sometimes tax evade and pay bribes? In this paper, I address this question by focusing on the effects of
personal income tax progressivity on the decision to become self&employed;. I develop a theoretical model of tax evading self&employed; individuals who
pay bribes to tax authorities. The model predicts that progressivity affects the decision to become self&employed; even if people tax evade. I then test
this prediction empirically using three sources of data. First, I use Russian longitudinal data and estimate the effects of progressivity on the individual
decision to become self&employed;. Second, I construct a data set of personal income tax schedules for 95 countries over 20 years and estimate the effects of progressivity on number of micro enterprises at the aggregate level. Third, I use Living Standards Measurement Surveys from 8 developing countries to estimate how much people are evading and the effect of progressivity on the amount that is not evaded. I find that increases in progressivity decrease the
probability of choosing selfemployment and decrease the number of micro enterprises. I also find that in countries with high tax evasion and frequent
bribes, self employment is less responsive to taxes than in the U.S.