Location-Based Tax Incentives for Non-Farm Rural Enterprises in Armenia

The paper analyses the effect of location-based tax incentives on rural non-farm small business performance in Armenia. It uses administrative panel data for the population of the registered taxpayers in the areas concerned, and the vast tax exemptions are granted for businesses operating in the selected set of border communities. Using an 'event study'-style difference-in-differences fixed effects estimator we initially find a negative effect of tax exemptions on the reported gross income of the affected enterprises and a positive effect on employment, mainly driven by a smaller subset of non-trade firms. To uncover these inconsistent results, we consider a possible channel for decreased reported revenues – changes in audit probabilities for the exempt businesses. Indeed, introducing controls for predicted audit probability eliminates the negative effects on gross revenues, while the positive effect on the number of employees persists, with even increased magnitudes. Gross income under-reporting incentives could emerge in the supply chain where the suppliers might be inclined not to report their sales thus inducing the exempted businesses to under-report their incomes as well. Given the short pre-treatment data, the long-term development common trend of treated and control communities is verified using satellite data on night-time illumination.