Developing Alternative Frameworks for Explaining Tax Compliance

James Alm, Jorge Martinez-Vazquez, Benno Torgler

• Publisher: Routledge
• Year: 2010
• ISBN:
  9781136970658
• Edition: 1
• Topic: Business
• Subtopic: Business generale
• Index: Business

Over the last several decades, there has been a growing interest in theoretical, empirical, and experimental work on all aspects of tax compliance and tax evasion. The essays in this volume summarize the existing state of knowledge of tax compliance and tax evasion, present new thinking about this issue, and analyze the empirical relevance of these new perspectives. The original essays in this volume represent an attempt to provide a framework on compliance that moves beyond the economics-of-crime perspective, one that provides a more complete understanding of individual (and group) decisions, and one that is more consistent with empirical evidence.

It is the insights of behavioural economics that provide much of the bases for these essays and the main theme running through this book is that the basic model of individual choice must be expanded, by introducing some aspects of behaviour or motivation considered explicitly by other social sciences.

Part I
Introduction to the volume

1
Developing alternative frameworks for explaining tax compliance

James Alm, Jorge Martinez-Vazquez, and Benno Torgler

Over the past several decades, there has been a growing interest in theoretical, empirical, and experimental work on all aspects of tax compliance and tax evasion. A common theme in much of this work is that the traditional economics-of-crime approach to compliance, while containing many insights, is simply inadequate as a framework for more fully understanding why people pay taxes. Rather, the basic model of individual choice must be expanded by introducing some aspects of behavior or motivation considered explicitly by other social sciences. Many of these aspects can be discussed under the general rubric of behavioral economics, broadly defined as an approach that uses methods and evidence from other social sciences (especially psychology) to inform the analysis of individual and group decision-making. The original chapters in this volume represent an attempt to provide exactly this new framework on compliance – one that moves beyond the economics-of-crime perspective, one that provides a more complete understanding of individual (and group) decisions, and one that is more consistent with empirical evidence.

The chapters in this volume summarize the existing state of knowledge of tax compliance and tax evasion, present new thinking about this issue, and analyze the empirical relevance of these new perspectives. They were presented at a conference entitled “Tax Compliance and Tax Evasion”, held in Atlanta in October 2007 and sponsored by the International Studies Program of the Andrew Young School of Policy Studies at Georgia State University.

It is useful at the start to identify more fully the basic insight – and the basic problem – with the standard economic approach to compliance. To date, the basic theoretical model used in nearly all research on tax compliance begins with the economics-of-crime model of Becker (1968), first applied to tax compliance by Allingham and Sandmo (1972).¹ Here, a rational individual is viewed as maximizing the expected utility of the tax evasion gamble, weighing the benefits of successful cheating against the risky prospect of detection and punishment, and individuals pay taxes because they are afraid of getting caught and penalized if they do not report all income. This approach gives the plausible and productive result that compliance depends upon audit rates and fine rates. Indeed, the central point of this approach is that an individual pays taxes because – and only because – of this fear of detection and punishment. The obvious policy implication here is that enforcement matters because enforcement can affect the financial considerations that motivate – at least in part – an individual’s compliance choices. However, it is essential to recognize that this approach also concludes that an individual pays taxes because – and only because – of the economic consequences of detection and punishment. Again, this is a plausible and productive insight, with the obvious implication that the government can encourage greater tax compliance by increasing the audit and the penalty rates. The many extensions of this economics-of-crime approach considerably complicate the theoretical analyses, and generally render clear-cut analytical results impossible. Nevertheless, these extensions retain the basic approach and the basic result: individuals focus exclusively on the financial incentives of the evasion gamble, and individuals pay taxes solely because they fear detection and punishment.

However, it is clear to many observers that compliance cannot be explained entirely by such purely financial considerations, especially those generated by the level of enforcement. The percentage of individual income tax returns that are subject to a thorough tax audit is generally quite small in most countries – almost always considerably less than 1 percent of all returns. Similarly, the penalty on even fraudulent evasion seldom exceeds more than the amount of unpaid taxes, and these penalties are infrequently imposed; civil penalties on non-fraudulent evasion are even smaller. Taxpayer audits are a central feature of the voluntary compliance system in all countries, largely because more frequent audits are thought to reduce tax evasion. Even so, a purely economic analysis of the evasion gamble suggests that most rational individuals should either under-report income not subject to source withholding or overclaim deductions not subject to independent verification because it is extremely unlikely that such cheating will be caught and penalized. However, even in the least compliant countries evasion never rises to levels predicted by a purely economic analysis, and in fact there are often substantial numbers of individuals who apparently pay all (or most) of their taxes all (or most) of the time, regardless of the financial incentives they face from the enforcement regime.

The basic model of individual compliance behavior therefore implies that rational individuals (especially those whose incomes are not subject to third-party sources of information) should report virtually no income. Although compliance varies significantly across countries and across taxes, and is often quite low, compliance seldom falls to a level predicted by the standard economic theory of compliance. It seems implausible that government enforcement activities alone can account for these levels of compliance; the basic model is certainly unable to explain this behavior. Indeed, the puzzle of tax compliance behavior may well be why people pay taxes, not why they evade them (Slemrod, 1992; Torgler, 2007). This observation suggests that the compliance decision must be affected in ways not fully captured by the basic economics-of-crime approach.

What other factors may explain why people pay taxes? It is this fundamental question that motivates the chapters in this volume, and it is the insights of behavioral economics that provide many of the bases for these chapters.

There are several specific themes that emerge in these chapters: What is the existing state of knowledge of tax compliance decisions? How can theory be expanded to reflect more accurately the many factors that underlie these decisions? What is the empirical evidence on the role of these many factors? Each of these themes represents a part in this volume.

In Part II, Erich Kirchler, Stephan Muehlbacher, Barbara Kastlunger, and Ingrid Wahl provide a useful summary of much the existing tax compliance literature. Their basic conclusion echoes that of this volume: there is much to be said for the standard economics-of-crime approach to tax compliance, but this approach goes only so far in explaining why people pay taxes. Indeed, they believe that alternative perspectives can help solve the puzzle of compliance. They argue especially for models that examine compliance choice as a social dilemma, that incorporate tax morale or social norms, and that utilize their own slippery slope framework.

The slippery slope model suggests that authorities’ position towards taxpayers is relevant for compliance: in an antagonistic tax climate, when tax authorities communicate a “cops and robbers” attitude, taxpayers will try to maximize their individual expected utility and only comply when forced to do so. On the other hand, in a synergistic climate, when authorities communicate a “service and clients” attitude, taxpayers will act on the basis of the perceived fairness of the system and comply voluntarily. As they conclude, “[t]he problem of tax compliance seems much too complex to be explained by a purely economic approach”. Rather, “[i]ncluding alternative approaches could help to understand the irrational behavior of taxpayers, and could expand the toolbox for an efficient tax policy”. These themes are repeated throughout the volume.

Part III develops the theoretical bases for these alternative approaches, by incorporating broader sets of individual motivations than simply financial considerations. John Cullis, Philip Jones, and Alan Lewis start with the standard homo economicus model, and then introduce social norms as an explanatory factor, including the ways in which one’s own norms can over time be influenced by others, and can in turn influence the dynamic path of the norms of others. Although difficult to define precisely, a social norm can be distinguished by the feature that it is process oriented, unlike the outcome orientation of individual rationality. A social norm therefore represents a pattern of behavior that is judged in a similar way by others, and which therefore is sustained in part by social approval or disapproval. Consequently, if others behave according to some socially accepted mode of behavior, then the individual will behave appropriately; if others do not so behave, then the individual will respond in kind. In particular, Cullis, Jones, and Lewis distinguish in their theoretical model between the prevalence of the social norm (e.g., the proportion of people actually pay their taxes honestly) and the strength of the norm (e.g., the proportion of individuals who think that they ought to pay taxes whether they actually do so or not). Clearly, the strength of the social norm can influence its prevalence, and can in turn be affected by the prevalence, and it is through these interactions that Cullis, Jones, and Lewis demonstrate the endogeneity of the norm, and also derive complicated dynamic effects. Some empirical evidence, derived largely from country estimates of the underground economy and also from the World Values Survey (WVS) questions on tax morale, provides some aggregate evidence that is at least somewhat consistent with their endogenous social norms theory.

Jan Schnellenbach also develops an alternative theory of tax compliance that moves well beyond the standard economic approach. In particular, he examines the impact of vertical reciprocity and horizontal reciprocity on individual compliance behavior. Vertical reciprocity represents the relationship between the individual and the state, and has sometimes been used in models of tax compliance; that is, do individuals feel that they are getting a fair return from government for their tax payments. Horizontal reciprocity is related to the relationship between individuals: individuals may be more likely to pay their taxes if they feel that others are doing so as well. Schnellenbach demonstrates that both types of reciprocity enter the calculus of a rational taxpayer; indeed, he argues that both types help influence the existence of a social norm, or a tax morale, that encourages compliance. He also demonstrates that the notions of reciprocity can be incorporated in a model of compliance, and that the resulting model enriches our understanding of compliance behavior. As Schnellenbach concludes, his model is only “…a first step towards incorporating results from the vast literature on reciprocity into theoretical reasoning about tax compliance”. Even so, his model is a useful first step.

Lars Feld and Bruno Frey take a somewhat similar approach, but shift the perspective to a voluntary individual compliance motivated mainly by trust in authorities – what they term a psychological tax contract approach. They develop their contractual approach by discussing the role of positive and negative incentives in paying taxes, building upon their previous work on how an intrinsic motivation to pay taxes can emerge and also on how this intrinsic motivation can be crowded out by government deterrence. If paying taxes is viewed as a contract, then government must provide appropriate levels of services to citizens when citizens make their tax payments. Failure by government to provide this quid pro quo can destroy the contract between individuals and the state. Deterrence itself can also negatively affect the psychological tax contract, because deterrence may lead taxpayers to believe that they are not being treated with mutual respect and mutual honesty. Feld and Frey identify a number of ways in which this contract can be either encouraged or discouraged by government (including the use of tax amnesties). They conclude by arguing that tax morale is a function of the fiscal exchange between government and taxpayers, political procedures that define the exchange, and the personal relationship between taxpayers and tax administrators. Feld and Frey make a convincing case that it is largely though the positive/reward channels that tax morale – and so tax compliance – can be improved.

The remaining chapters provide various types of empirical support for a broader, interdisciplinary approach to tax compliance. This empirical evidence can be separated into several categories: evidence on financial incentives (including audit systems), evidence on governance, and specific case studies. Each of these three categories is organized as a separate section.

In Part IV, Calvin Blackwell examines the role of financial incentives. He uses data generated from the large number of tax compliance experiments that have been published in the past 30 years, and combines these separate data sets into a single data set using meta-analysis, an econometric method that increases the power of the statistical analysis from the increased number of data points and from the increased variation in the dependent variable(s). He focuses his meta-analysis on the compliance impact of the tax rate, the fine rate, the audit rate, and the public good return rate. Blackwell’s empirical results largely confirm those of the previous 26 experimental papers that he includes in his data set; that is, compliance increases with increases in the fine rate, the audit rate, and the public good return rate. He finds that the estimated compliance elasticities are comparable to but slightly larger than those of the previous studies. He also finds that compliance declines with an increase in the tax rate, but that this impact is not statistically significant.

Brian Erard and Jonathan Feinstein also focus on the financial incentives, this time looking at audit mechanisms employed by the tax authorities. They are able to make two major improvements over much previous empirical work. First, they incorporate fully the multi-stage aspect of most audit schemes. There are numerous distinct, decisions made by auditors in the course of a typical “audit”: which returns should be audited, what type of audit should be conducted, what mandatory classification issues should be examined, what additional unclassified issues should be examined, and the like. These decisions are made at different points in the audit process and by different individuals, and these types of sequential issues require sophisticated econometric modeling methods to be examined correctly. Second, they are able to use data collected from the recent Internal Revenue Service (IRS) National Research Program (NRP), in order to examine the effectiveness of the audit processes. Erard and Feinstein find that there is considerable heterogeneity across auditors (and across income types) in their ability to detect non-compliance. They also find that the NRP classification scheme is largely successful in identifying specific income types that should be examined in an audit, although there are some cases in which the classification process can – and should – be improved. In short, Erard and Feinstein demonstrate that the financial impact of audits matters in individual compliance decisions, but that the specific details of the audit process also matter.

Part V contains three chapters that look at the empirical impact of more broadly defined societal institutions, especially those of government and governance. Benno Torgler, Markus Schaffner, and Alison Macintyre first provide convincing empirical evidence that tax morale, defined as one’s intrinsic motivation to pay taxes, has a significant impact on tax evasion. They use data from a wide range of sources – survey data, laboratory experimental data, and field data – and they find in each instance that lower tax morale is strongly correlated with greater tax evasion. Importantly, they then go on to explore empirically the determinants of tax morale, focusing specifically on how governance and attitudes toward governance affect tax morale. Torgler, Schaffner, and Macintyre use survey evidence from the European Values Survey (EVS), which has a number of questions that relate to citizen attitudes toward the quality of governance. They use these responses to construct six different measures of governance quality: citizen voice and government accountability; political stability and the absence of violence; government effectiveness; regulatory quality; the rule of law; and control of corruption. There are also variables in the EVS that measure trust in the parliament and trust in the justice system, and these variables are included in the ordered probit estimation. Their results consistently indicate that governance quality, however measured, has a positive and signif...

Table of contents

• Routledge international studies in money and banking
• Contents
• Figures
• Tables
• Contributors
• Part I Introduction to the volume
• Part II A review and critique of the existing literature
• Part III Expanding the standard theory of compliance
• Part IV Empirical evidence on financial incentives
• Part V Empirical evidence on governance
• Part VI Case studies
• Index