The determinants of the size distribution of firms in Uganda

The size distribution of firms in Uganda is highly skewed to the right both in 1997 and 2005. In this article I examine a potential explanation behind the shape of the size distribution in Uganda and identify, using data from 1997, a distortion from the tax environment that seems to bring together observed patterns in firm size. Two changes in tax audit strategy generate an increase in expected costs from taxation and entice entrepreneurs to restrain their hiring of labour in order to pass under tax officials’ radar. First, we observe a steep rise in audit probability at 10 employees, which generates a cluster of firms at 8 employees. Second, tax officials start relying on sales instead of size to set audit targets for firms with more than 25 employees. This change also implies that tax officials extract more taxes and bribes from the larger firms they inspect. The effect of this second change is so important that it generates a measurable discontinuity in the density of firm size around 27 employees. I show that most of the 1997 patterns are still observable almost a decade later.