Concepts. Economic psychology: from tax compliance and evading to psychological contract. Basic model of tax evasion. Economic theory of crime

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1 Economic psychology: from tax compliance and evading to psychological contract Velli Parts, MSc Concepts tax avoidance - an attempt to reduce tax payments by legal means (e.g. by exploiting taxloopholes) (maksudest hoidumine) tax evasion - an illegal reduction of tax payments (e.g. underreporting income or by stating higher deduction-rates) (möödahiilimine) tax flight - the relocation of businesses in order to save taxes (e.g. making use of offshore tax havens) (põgenemine) 2 Basic model of tax evasion A purely economic analysis of the evasion gamble implies that most individuals would evade if they are rational, because it is unlikely that cheaters will be caught and penalized. Alm, McClelland and Schulze (1992, p. 22) In order to prevent individuals from free riding on public goods, coercive taxation has to be used. The tax code is enforced by a system of fines and audits. Individuals decide by maximising expected utility such that a risk-averse individual, who earns a certain amount of money, chooses the share of income he/she wants to declare to the tax authority. 3 4 Basic model of tax evasion (2 The incentives for rational and selfish individuals to voluntarily pay taxes are pretty low because undeclared income is not taxed. Therefore the individual needs to face a certain threat of punishment if he/she does not truthfully declare his/her income. He/she is audited with a certain probability of detection and fined by a penalty tax rate when tax evasion has been detected. 5 Economic theory of crime The extent of deterrence, as the product of the probability of being detected and the size of the fine imposed, determines the amount of income evaded. However, in view of the low deterrence applied in most countries, because of a low intensity of control or small penalties, taxpayers should evade more than they actually do, that is, compliance is too high. 6

2 Important questions for (tax) authorities: (i) what features of a tax induce (non)compliance; (ii) how important are the evasion opportunities implicit in tax legislation; (iii) what role does the characteristics of taxpayers play; (iv) what are taxpayer perceptions of the fairness of a tax; (v) what are taxpayer perceptions about the fairness of any associated expenditure; (vi) what are the economic and equity consequences of non-compliance. 7 8 Tax evasion loss of revenue around US$100 billion (1997) => less funds for crucial collective goods and government services, contributes to social inequality and institutional mistrust related to the underground/shadow economy => reputation, economic growth Netherlands-the average sizes in and % and 13.0% of GDP respectively Albania % in 1999/ What has been found? tax evasion increases with the tax rate and decreases with the level of fines and with the audit probability (Friedland et al., 1978). tax evasion is lower when the proceeds are used to provide a public good (Alm et al., 1992) decision whether or not to evade is made jointly with the decision on how much effort to put in income earning activities (Collins & Plumlee, 1991). tax evasion increases with income and women evade taxes less than men do (Giese 10 & Hoffman, 1999). Role of non-economic factors A large subset of people never cheat, because they appear to believe that cheating is wrong Attitudes toward risk Social norms are important operationalised as a perceived prevalence or acceptance of tax evasion among a reference group People s social networks and associations help shape their perceptions, norms and attitudes, which then influence their responses to imagined and actual sanctions (Smith & Kinsey, 1987) Taxpayers perceptions about evasion and fairness have a direct influence on compliance - individuals who perceive evasion as prevalent, and/or to be an insignificant crime, tend to be less compliant (Porcano 1988) 11 Tax ethics -a belief that there is a moral imperative that one should deliberately comply. Tax ethic is related to person s fundamental values. Perceptions of fairness and equity Distributive fairness regards one s own tax burden, either one s personal tax burden compared with that of similar others (horizontal fairness) or the tax burden across different taxpayer groups (vertical fairness). Exchange fairness - evaluations of the relationship between taxes paid and government benefits and services that are offered in return. Wenzel (2003). It is generally assumed that strongly held tax ethics & perceptions of fairness are positively related 12

3 Institutional factors direct democracy and individual voting on different aspects of the fiscal system decrease tax evasion tax evasion decreases with a higher trust in governmental institutions, a higher perceived fairness of the tax administration and with a perceived equity of the fiscal exchange federalism and decentralization appear to be beneficial to tax compliance Theories of non-compliance the subject as an amoral profit-seeker whose actions are motivated wholly by rational calculation of costs and opportunities this assumption underlies the deterrence theory approach - a taxpayer is likely to break the law unless anticipated legal penalties exceed the additional earnings that could be made by evading tax Limitation of the theory It does not satisfactorily explain the high levels of observed compliance USA: majority of taxpayers are compliant even when the possibility of detection and punishment for noncompliance is obviously slim Australia - taxpayers report being generally compliant even when they believe others are not => taxpayers attitudes towards the tax system, rather than (or in addition to) purely economic calculations (opportunities for cheating) or fear of punishment, are important in explaining taxpayers non-compliance = attitudes are more important than opportunities in 15 determining taxpayers behaviour WVS

4 Tax morale Tm - an individual s intrinsic willingness to pay taxes self-employed taxpayers vs working for other people or organizations; country differences Related to taxpayer ethics - the norms of behavior governing citizens as taxpayers in their relationship with the government. Tm is likely to be affected by the nature of the fiscal exchange between taxpayers and government. When the government trusts taxpayers, it will be rewarded by greater taxpayer trust in government, which also improves tax morale (reciprocity can be an important inducement for compliance (e.g., positive rewards for honest behavior). 19 Political citizen model Kagan and Scholzs (1984) Basic idea: when amoral calculators fail to comply, it is because they calculate that the costs of compliance exceed the benefits. For political citizens, however, noncompliance arises because they are not persuaded that compliance is a just obligation of citizenship. => unreasonable behaviour by regulators generates resistance to compliance disrespect for citizens, or 20 arbitrary refusal to take their concerns into account in the enforcement process Result Citizen response is likely to be weakened respect for compliance with the law. => Non-compliance could be interpreted as taxpayers expressive rebellion against tax authority enforcement actions, or laws that are perceived to be illegitimate. 21 How taxation is represented in the minds of taxpayers and tax-officers? Tax complexity A high percentage of taxpayers perceive tax law to be too complex. Tax law and tax in general are evaluated negatively and willingness to comply suffers assumption of a positive relationship between subjective understanding and tax attitudes has received empirical support 23 The administration of law is sometimes ambiguous due to unclear regulations taxpayers find it difficult to file their own tax returns correctly perceive tax law complexity and ambiguity as causes of tax avoidance. A tax system has little legitimacy and reduced prospects of achieving voluntary compliance If it allows practice of legally avoiding taxes using expert advice (expensive) allows tax authorities to treat tax files inconsistently increasing shadow economy activity and tax avoidance rates 24

5 Solution? 1. fundamental reconsideration of the law or enactment of new rules? 2. improvement in the interaction between tax officials and taxpayers, in order to support and improve cooperation and voluntary compliance? Example: Compliance Model of the Australian Taxation Office (ATO) which emphasizes understanding taxpayer behaviour, and focuses on building community partnerships, increased flexibility in ATO operations to encourage and support cooperation, and compliance. 25 How are shared beliefs and evaluations related to taxpayer compliance? Shared tax views facilitate positive interaction, and mutual satisfactory interaction btw tax-payers and tax-officers => enhance taxpayers willingness to cooperate and comply. Willingness to cooperate is assumed to be a mediator between shared views and tax behaviour. 26 Research results Taxpayers intent to report timely and correctly is higher if self reported tax knowledge is high and tax law is perceived as not too complex, tax mentality and attitudes towards government spending are positive, if tax ethics are high, if horizontal and vertical fairness are perceived to be high, and if tax staff and tax preparers support is perceived as high. Only social norms were not significantly related to willingness to cooperate which may be due to the significant correlation with attitudes towards the government. Willingness to cooperate appears to be a mediator between perceptions and evaluations and tax behaviour NB! Findings in tax psychology suggest that actual behaviour is dissimilar to self reported behaviour intentions, such as willingness to cooperate, and is explained only to some extent by self reported beliefs and evaluations. 29 Closing the gap between theory of non-compliance and facts 1. The probability of being detected is subjective, implying that individual perceptions of being caught when cheating on the tax code are much higher than objective probabilities of detection. 2. Tax morale serves as an explanation for compliance rates = tax compliance is driven by a psychological tax contract between citizens and tax authorities => the way they taxpayers are treated affects their tax 30 morale, and therefore their willingness to pay taxes

6 Crowding Theory external interventions, in the form of rewards or sanctions, may crowd out intrinsic motivation NB! the objective of the tax authority in this environment is to maximise expected net revenue. TAX COMPLIANCE AS THE RESULT OF A PSYCHOLOGICAL TAX CONTRACT The relationship between taxpayers and tax authorities can be modelled as an implicit or relational contract which also involves strong emotional ties and loyalties The impact of deterrence on tax compliance 1. If the fine for minor offences is used, a higher fine increases tax evasion because it is perceived to be too intrusive. 2. If the penalty for tax fraud or major offences is chosen, a higher fine reduces tax evasion because it makes clear that the psychological tax contract is at stake. 33 The impact of rewards receiving certain types of rewards for being a good taxpayer is perceived as supporting and tends to bolster and raise tax morale the way rewards are handed out to good taxpayers is essential for its effects type of reward; certain or random allocation The evidence from neuroscience strongly supports the conjecture that unexpected rewards more strongly affect behaviour in the predicted directions 34 The treatment of taxpayers Respectful treatment the procedures used by auditors in their contact with taxpayers are to be transparent and clear treating taxpayers as contract partners instead of inferiors in a hierarchical relationship Tax morale is therefore a function of (1)the fiscal exchange where taxpayers get public services for the tax prices they pay, (2)the political procedures that lead to this exchange and (3) the personal relationship between the taxpayers and the tax administrators