Can strategic uncertainty help deter tax evasion? An experiment on auditing rules

This paper adds to the economic-psychological research on tax compliance by experimentally testing a simple auditing rule that induces strategic uncertainty among taxpayers. Under this rule, termed the bounded rule, taxpayers are informed of the maximum number of audits by a tax authority, so that the audit probability depends on the joint decisions among the taxpayers. We compare the bounded rule to the widely studied flat-rate rule, where taxpayers are informed that they will be audited with a constant probability. The experimental evidence shows that, as theoretically predicted, the bounded rule induces the same level of compliance as the flat-rate rule when strategic uncertainty is low, and a higher level of compliance when strategic uncertainty is high. The bounded rule also induces distinctive tax evasion dynamics compared to the flat-rate rule. The results suggest that increasing the level of strategic uncertainty among taxpayers could be an effective device to deter tax evasion.     

Uncertainty resolution in tax experiments: Why waiting for an audit increases compliance

Tax compliance in a between-subjects experiment was higher when the uncertainty about the occurrence of an audit was not resolved until three weeks after participants had filed their tax returns than in a control treatment with immediate uncertainty resolution. Results have important implications for experimental tax research where providing immediate feedback whether participants are audited is common practice.     

The bomb-crater effect of tax audits: Beyond the misperception of chance

The experimental literature has identified the Bomb Crater Effect (BoCE), i.e., the fact that tax compliance drops immediately after a taxpayer is audited. From a theoretical perspective, BoCE has been explained either by the misperception of chance, also known as the gambler’s fallacy, or by the loss repair effect. The aim of this paper is to look more closely at the former. We run a laboratory experiment in which the information set is relatively rich but the implementation of the Bayesian updating process is fairly simple. By doing so, we are able to elicit a range of consistent but heterogeneous probability beliefs and to distinguish between Bayesian and non-Bayesian subjects. We obtain two major results concerning Bayesian subjects. First, they exhibit a strong and robust short-run BoCE. Second, they are seemingly not affected by the audits of other taxpayers in their compliance decision. These results are robust to different definitions of Bayesianity as well as to different specifications and conflict with the evidence that Bayesian agents correctly perceive the chance of being audited. In turn, these findings suggest that the existing explanations of the BoCE are not satisfactory and that alternative theories are needed.     

ON THE INTERNAL REVENUE SERVICE'S SERVICE AND ENFORCEMENT

Built on the seminal work of Graetz et al. (1986), this study considers a model of tax compliance in which the Internal Revenue Service (IRS) services as well as audits taxpayers as in the real world. Taxpayers are uncertain about whether their incomes are eligible for deduction/exemption, and may seek advice from the taxpayer service provided by the IRS to mitigate the uncertainty. We show: (1) while the society's preferred quality of taxpayer service is likely to be sufficiently high, the IRS's preferred quality of taxpayer service is only at an intermediate level; and (2) the conflict between the society and the IRS tends to be intensified as the cost of tax audits becomes lower. Evidence in support of our results is addressed. We also extend our model to addressing the issue of corruption in tax administration and to considering a dynamic model. (JEL D82, H26, K42)     

Honesty or dishonesty of taxpayer communications in an enforcement regime

In many settings the true likelihood of capture when engaging in an illegal activity, such as tax evasion, is not well known to an individual. “Official” statements from the tax administration regarding enforcement effort provide some information. In addition, “informal”, or “unofficial”, communication among taxpayers can supplement these official announcements, but individuals do not know with certainty whether such unofficial information is honest (or accurate) versus dishonest (or inaccurate). We examine the truthfulness of an individual’s revelation of unofficial information to other individuals, along with the factors that affect any revelation, focusing on the intrinsic motivations for revelations. Our experimental design allows us to examine the type and the honesty of messages that an individual chooses to send to other individuals regarding their own audit outcome and their own compliance behavior. Our results indicate that most individuals send accurate messages about their own audit outcomes and their own compliance behaviors. Nevertheless, many individuals are also systematically dishonest about being audited; that is, we observe a significant tendency for individuals to claim that they were audited when they were not. We also observe a strong interaction between individuals’ audit outcomes and their compliance behaviors, so that individuals who engaged in tax evasion and who were audited were more truthful in their communications than those whose tax evasion went undetected.     

A self-funding reward mechanism for tax compliance

We compare in a laboratory experiment two audit-based tax compliance mechanisms that collect fines from those found non-compliant. The mechanisms differ in the way fines are redistributed to individuals who were either not audited or audited and found to be compliant. The first, as is the case in most extant tax systems, does not discriminate between the un-audited and those found compliant. The second targets the redistribution in favor of those found compliant. We find that targeting increases compliance when paying taxes generates a social return. We do not find any increase in compliance in a control treatment where individuals audited and found compliant receive symbolic rewards. We conclude that existing tax mechanisms have room for improvement by rewarding those audited and found compliant.     

AUDIT STATE DEPENDENT TAXPAYER COMPLIANCE: THEORY AND EVIDENCE FROM COLOMBIA

We develop and analyze a dynamic model of individual taxpayer compliance choice that predicts “audit state dependent taxpayer compliance,” by distinguishing between forward-looking versus myopic versus naïve behavior. We then test experimentally the audit state dependent model by reporting the results from the first tax compliance experiment run in Colombia. We find that subjects' compliance rates increase with greater enforcement. We also find more novel results: fine rates should be increased after an audit, and “nudging” myopic individuals toward reporting a constant rather than a fluctuating proportion of income would benefit both the taxpayer and the tax authority.(JEL H26, C91)     

Compliance costs caused by agency action? Empirical evidence and implications for tax compliance

Compliance costs of taxpayers should not only be affected by the tax law itself but also by its implementation through the tax authorities. In this paper we analyze the effect of authority behavior on the burden of complying with tax regulations. Using survey data of Belgian businesses, we develop an estimation strategy to overcome simultaneity bias by the construction of proxy variables. According to our estimate, a customer-unfriendly tax administration increases the average compliance burden by about 27%. Our outcome has interesting implications for further research. First of all, authority behavior does not only affect “soft” tax compliance factors like fairness and trust, but also “hard” aspects like costs. Second, the distribution of administrative cost burdens between the taxpayer side and the authorities may be important regarding the cost-efficiency of the tax system as a whole.     

An examination of the impact of subject selection on hypothetical and self-reported taxpayer noncompliance

Understanding taxpayer noncompliance involves the use of government reported statistics as well as taxpayer self-reported data. Both sets of data are subject to biases, but both have information to offer tax researchers. The present study addressed whether self-reported compliance rates and hypothetical reporting decisions correspond to government reported compliance rates and whether self-reported compliance rates correspond to hypothetical reporting decisions. The relationships were found to be positively correlated, but the results were influenced by the method of sample selection for the subjects. The findings of this study provide additional insight to help researchers cautiously interpret results from behavioral tax studies.     

EFFICIENT TAX REPORTING: THE EFFECTS OF TAXPAYER LIABILITY INFORMATION SERVICES

The complexity of the individual income tax system can give rise to both under‐ and overreporting of liability, thus creating a wedge between taxpayer perceptions of the price of public services and their actual cost, and potentially leading to budget misallocations and associated efficiency losses. This study uses theory and experiments to evaluate the effectiveness of taxpayer service programs that endeavor to resolve uncertainty over tax liability. To do so, we induce uncertainty over tax liability and investigate the effects of both service accuracy and reliability. We find participants are less likely to file when tax liability is uncertain but the provision of information offsets this effect; furthermore, it appears that simply providing a service, even one that imperfectly reveals liability, increases the propensity to file and the accuracy of the filing. When a service that promises to resolve uncertainty completely is requested but not delivered, the result is underreporting even more severe than in a setting where no service is available. (JEL H2, H26, C91)     

Taxpayer attitudes toward tax audit risk

Theoretical analyses on tax evasion usually assume that the taxpayer's behavior conforms to the Von Neumann-Morgenstern axioms for behavior under uncertainty, namely that the taxpayer is generally risk averse. This study found that the taxpayers' attitudes toward risk could be affected by (1) whether taxpayers perceive a tax payment as reduced income or as a loss; and (2) the magnitude of the tax savings and penalty structure. The findings, in general, agree more with the prospect theory than with the classical expected utility theory.     

Targeting occupations with varying reputations to increase tax revenue

If the government's goal is to raise tax revenue in a cost-effective manner, which (if any) occupation categories could be targeted with a higher probability of an audit to yield increased revenue? Looking beyond mere opportunity to evade (e.g., self-employment) and starting from the premise that taxpayers in certain occupations evade more than others, the issue is whether these taxpayers respond to a change in the audit rate. Theory suggests that compliance increases in response to higher audit rates; the occupations with the higher evaders could therefore be targeted. This theory is tested by drawing a connection between occupation, reputation, and tax compliance. We assume that taxpayers in occupations with high need for reputation respond to a lower extent to increased tax audits than taxpayers whose achievement does not depend on reputation. The results support the effectiveness of raising tax revenue by targeting specific occupations, non-managers, with a higher probability of an audit.     

An agent-based model of network effects on tax compliance and evasion

Agent-based models are flexible analytical tools suitable for exploring and understanding complex systems such as tax compliance and evasion. The agent-based model created in this research builds upon two other agent-based models of tax evasion, the Korobow et al., 2007, Hokamp and Pickhardt, 2010 models. The model utilizes their rules for taxpayer behavior and apprehension of tax evaders in order to test the effects of network topologies in the propagation of evasive behavior. Findings include that network structures have a significant impact on the dynamics of tax compliance, demonstrating that taxpayers are more likely to declare all their income in networks with higher levels of centrality across the agents, especially when faced with large penalties proportional to their incomes. These results suggest that network structures should be chosen selectively when modeling tax compliance, as different topologies yield different results. Additionally, this research analyzed the special case of a power law distribution and found that targeting highly interconnected individuals resulted in a lower mean gross tax rate than targeting disconnected individuals, due to the penalties inflating the mean gross tax rate in the latter case.     

Political–economic equilibrium when parties represent constituents: The unidimensional case

 A political–economic environment is studied in which two parties, representing different constituencies of citizens, compete over a proportional tax rate to be levied on private endowments, to finance a public good. Although parties know the distribution of citizen traits (preferences and endowments), they are uncertain about the distribution of traits among the citizens who will turn up at the polls. This uncertainty engenders an endogenously derived function π(t ₁, t ₂) giving the probability that any one tax policy t ₁ will defeat another t ₂ in the election. Equilibrium existence theorems are proved, and the nature of equilibrium is compared with the equilibrium that exists when Downsian parties (ones whose objective is to maximize the probability of victory) face uncertainty. Both constituency-representing parties and uncertainty are needed to generate equilibria in which parties propose different policies. Received: 4 April 1995/Accepted: 2 April 1996     

Dynamics of tax evasion with back auditing,social norm updating,and public goods provision – An agent-based simulation

Income tax evasion dynamics and social interactions are analyzed with an agent-based model in heterogeneous populations. One novelty is the combined analysis of back auditing and ageing, which allows for incorporating psychological findings with respect to social norm updating over a taxpayer’s life cycle. Another novelty concerns individual’s social behavior regarding a Pareto-optimal provision of public goods. Simulation results support the counterintuitive conclusion drawn elsewhere in the literature that income tax compliance may decrease with raising marginal per capita returns (MPCRs). Yet, back auditing seems to have by far the strongest impact on the dynamics of fiscal fraud and also can help to curb the extent of tax evasion (ETE).     

WHAT MOTIVATES POLITICAL PREFERENCES? SELF‐INTEREST,IDEOLOGY, AND FAIRNESS IN A LABORATORY DEMOCRACY

Substantial prior literature has established that subjects in laboratory experiments are typically willing to sacrifice their own well being to make financial allocations more equal among participants. We test the applicability of this result in an environment that contains some of the key contextual issues that are usually excluded from more abstract games, but which might be important in situations involving income redistribution. Our general finding is that votes for a redistributive tax are almost entirely in accordance with self‐interest: above‐average earners vote for low tax rates and below‐average earners vote for high tax rates. A measure of subjects' preferences for fairness or equality, their self‐reported economic ideology, is not directly related to their voting behavior in this experiment. Because the ideology measure should be correlated with any intrinsic preferences regarding inequality aversion, we conclude that any preferences for fairness or inequality that our subjects possess are not strong enough to overcome self‐interest in this context. We do, however, find evidence for a possible indirect effect of ideology on choice behavior in that more conservative subjects tend to be more responsive to their self‐interest than the more liberal subjects. (JEL C90, D63)     

Informal sector taxes and equity: Evidence from presumptive taxation in Zimbabwe

Using a mixed‐methods approach, this article evaluates the equity implications of Zimbabwe's presumptive tax system, introduced in 2005 to raise revenue from the country's growing informal sector. The representative taxpayer method, which compares the hypothetical tax burdens of formal and informal sector taxpayers at varying income levels, shows that the presumptive tax regime undermines both vertical and horizontal equity. In addition, interviews with key informants from the tax authorities, other relevant organizations and informal sector operators were conducted to probe issues around collection, compliance and perceptions of fairness. The qualitative data suggest that weak enforcement, with more visible informal activities bearing the brunt of the tax burden, and selective (and sometimes politically motivated) application of the legislation, compromise equity further.     

The distinct role of group-central and group-peripheral norms in taxpaying behaviour

In recent years, a social identity approach has been used to help understand why people do or do not pay tax [see Taylor, 2003; Wenzel, M., 2002. The impact of outcome orientation and justice concerns on tax compliance: the role of taxpayers’ identity. Journal of Applied Psychology 87, 629–645; Wenzel, M., 2004. An analysis of norm processes in tax compliance. Journal of Economic Psychology 25, 213–228; Wenzel, M., 2005. Misperception of social norms about tax compliance: from theory to intervention. Journal of Economic Psychology 26, 862–883; Wenzel, M., 2007. The multiplicity of taxpayer identities and their implications for tax ethics. Law & Policy 29, 31–50]. This research, which has focused almost exclusively on national identity, indicates that the more people identify with a group, the more likely they are to adhere to its tax norms and values. However, conformity to group norms may be more nuanced than this, and depend on (a) the meaning or content of the identity in question [e.g., Turner, J.C., 1999. Some current themes in research on social identity and self-categorization theories. In: Ellemers, N., Spears, R., Doojse, B. (Eds.), Social Identity: Context, Commitment, Content. Blackwell, Oxford, pp. 6–34] and (b) whether the norms and values are central or peripheral to the content of that identity. In line with this idea, two studies explored whether the concept and act of taxpaying are more central to what it means to be a member of one's nation than of one's occupational group. Both studies confirm this expectation. Importantly, the findings also suggest that although occupational groups have different norms and values in relation to pre-tax behaviours (e.g., how to deal with extra income), these too can be peripheral to what it means to a group member. If norms are peripheral to identity content, conformity to such norms may be independent of group identification.     

TAX-RATE UNCERTAINTY, FACTOR SUPPLIES, AND WELFARE

Uncertainty about prospective changes in tax rates may increase factor supplies, and hence the tax base, permitting a reduction in tax rates that could result in a net increase in welfare. Under empirically relevant assumptions about attitudes towards risk we find that when an individual exclusively saves or works, the tax base rises in response to greater tax-rate uncertainty, so that welfare could indeed increase. However, when an individual both saves and works, the supply of the randomly taxed factor declines with increased uncertainty, implying that tax revenue and welfare decrease when the nonrandom tax rate is sufficiently low.     

Social networks and occupational choice: The endogenous formation of attitudes and beliefs about tax compliance

The paper analyses the emergence of group-specific attitudes and beliefs about tax compliance when individuals interact in a social network. It develops a model in which taxpayers possess a range of individual characteristics – including attitude to risk, potential for success in self-employment, and the weight attached to the social custom for honesty – and make an occupational choice based on these characteristics. Occupations differ in the possibility for evading tax. The social network determines which taxpayers are linked, and information about auditing and compliance is transmitted at meetings between linked taxpayers. Using agent-based simulations, the analysis demonstrates how attitudes and beliefs endogenously emerge that differ across sub-groups of the population. Compliance behaviour is different across occupational groups, and this is reinforced by the development of group-specific attitudes and beliefs. Taxpayers self-select into occupations according to the degree of risk aversion, the subjective probability of audit is sustained above the objective probability, and the weight attached to the social custom differs across occupations. These factors combine to lead to compliance levels that differ across occupations.