u nderstanding i ndividual t ax c ompliance gareth d. myles university of exeter and tax...
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UNDERSTANDING INDIVIDUAL TAX COMPLIANCE
Gareth D. Myles University of Exeter and Tax Administration Research CentreIn collaboration with
Miguel Fonseca Exeter and TARCShaun Grimshaw Exeter and TARCNigar Hashimzade Durham and TARCTim Miller Exeter and TARCMatthew Rablen Brunel and TARC
The financial support of ESRC/HMRC/HMT is gratefully acknowledged.
INTRODUCTION
An understanding of the individual tax compliance decision is important for revenue services
It is necessary for designing good policy interventions that reduce the tax gap
Tax compliance is an area where orthodox analysis has been challenged by behavioural economics
This talk explores the limitations of the orthodox analysis and suggests improvements
STARTING POINT A natural starting point is to consider
non-compliance as a gamble A non-compliant taxpayer is gambling
on not being audited and discovered Let the taxpayer have income Y and
declare income X, with 0 ≤ X ≤ Y Income when not caught is Ync = Y – tX If the fine is F then income when
caught is Yc = [1 – t]Y – Ft[Y – X]
ORTHODOX ANALYSIS
If income is understated the probability of being caught is p
Applying expected utility theory implies the optimal declaration X solves
max{X} E[U(X)] = [1 – p]U(Ync) + pU(Yc) There are two states of the world:
In one state the taxpayer is not caught evading and income is Ync
In the other state they are caught and income is Yc
EVASION DECISION
cY
ncY
Yt1
Yt1 Y
YFt 11 0X
YX
*X
• The choice problem is shown in Figure 1
• The optimal declaration achieves the highest indifference curve
• The taxpayer chooses to locate at the point with declaration X*
• This is an interior point with 0 < X* < Y
• Some tax is evaded but some income is declared
Figure 1: Interior choice:0 < X* < Y
NON-COMPLIANCE Non-compliance occurs when the
indifference curve is steeper than the budget constraint at X = Y
This is true when p < 1/[1 + F] If this condition is satisfied the taxpayer
should be non-compliant It is independent of preferences When F = 1 the taxpayer will evade if p < ½ The model predicts that for realistic
parameter values every taxpayer should be non-compliant
TAX EFFECT
cY
ncY Yt̂1 Y
YFt 1ˆ1
newX
oldX
YFt 11
Yt1
Yt1
Yt̂1
• An increase in the tax rate moves the budget constraint inward as in Figure 2
• The outcome is not clear-cut
• If taxpayers are more willing to take on a fixed gamble as income increases then a tax increase reduces tax evasion
• This is because the fine is Ft so an increase in the t raises the penalty
Figure 2: Tax rate increase
TESTING THE RESULTS
The model could be tested by comparing its predictions against data
The publicly available data is very limited and has not been adequate to test the model
An alternative strategy has been to use experiments to test the model
How does the behaviour of experimental subjects compare to the predictions?
EXPERIMENTS
Most experiments have been run in experimental labs using students as subjects
TARC has gone beyond this by using online experiments with large numbers of actual taxpayers
The results of the experiments are not supportive of the orthodox analysis
The experiment in which you participated will illustrate this
WINNER
The lowest payoff was 122700 The highest payoff in the experiment
was 215000 The winner of the prize is:
Mark PhillipsUniversity of Southern
California
STRUCTURE
You were enrolled randomly in one of two experiments
In one experiment Part A involved tax compliance
In the other experiment Part A involved an investment decision
For both experiments Part B tested attitude to risk
The tax experiment will be discussed first
COMPLIANCE EXPERIMENT
What does the model predict about behaviour?
For all sets of parameter it was the case that p < 1/(1 + F)
So the model predicts every participant should have been non-compliant
Non-compliance might vary between participants
But the optimal strategy to maximise expected income is to declare nothing
COMPLIANCE EXPERIMENT
The data do not match these predictions
10 participants out of 50 declared honestly
Only 4 declared nothing every time (including me!)
Some participants were partially non-compliant
The choices are summarised in the histograms that follow
COMPLIANCE EXPERIMENT
COMPLIANCE EXPERIMENT
INVESTMENT EXPERIMENT
The investment experiment involved the allocation of saving
There was a risky asset and a safe asset The payoffs were structured so that the
risky asset was a better-than-fair bet The optimal strategy to maximise
expected income is to put everything into the risky asset
The histograms summarise the responses
INVESTMENT EXPERIMENT
INVESTMENT EXPERIMENT
COMBINATION
Why did we run two versions of Part A? The compliance experiment and the
investment decision had the same payoffs
If tax compliance were just a gamble then the experiments should have the same choices
This was the reason for randomising participants and experiments
The comparison of histograms shows the pattern of choices are very different
COMBINATION
OBSERVATIONS
These results are not explained by attitudes to risk
OBSERVATIONS
This experiment was first reported by Baldry in 1986
It always works! He concluded that tax compliance was
not just a gamble The comparison shows that the
orthodox analysis is not correct Recent research has explored how it
should be revised Some of this research is now reviewed
OPPORTUNITIES
Not all taxpayers have an opportunity to be non-compliant
Employment income is usually subject to third-party reporting or withholding
Self-employment opens the opportunity for non-compliance
Occupational choice should be modelled
The potentially non-compliant self-select into occupations where non-compliance is possible
OCCUPATIONAL CHOICE
Self-employment can be successful (S) or unsuccessful (U)
For optimal evasion, Ei*, the payoff from self-employment is
EU = (1–q) EUu (Eu*) + qEUs (Es*) The choice of occupation is determined
(partly) by risk aversion Low risk aversion implies self-
employment and significant non-compliance
BEHAVIOURAL APPROACH
The next issue is why be honest if it does not pay?
The problem that confronts modelling is how to maintain rationality but reach different conclusions
This issue has had to be addressed in many areas of economics
“Anomalies” are observed decisions that do not fit theoretical predictions
These have lead to the development of behavioural economics
BEHAVIOURAL APPROACH
Behavioural economics can be seen as a loosening of modelling restrictions
Two different directions can be taken:(i) Revise the assumption about information underlying the decision
(ii) Reconsider the private nature of the compliance decision
This allows additional factors to be incorporated in the evasion decision
INFORMATION
In the orthodox model the taxpayers use the objective probability of audit and know the fine
Two criticisms1. The probability is not public information2. The fine is not widely known
There is evidence that subjective beliefs about unknown variables inflate the probability of bad events
NON-EXPECTED UTILITY
Let w1(p, 1 – p) and w2(p, 1 – p) be weighting functions that depend on p and 1 – p
More weight is given to the bad outcome so w1(p, 1 – p) > p
The general form of non-expected utility is
V = w1(p, 1 – p)U(Yc) + w2(p, 1 – p)U(Ync) The inflation of the probability will
raise the rate of compliance
ALTERNATIVES
Some of the alternatives that have been applied to the compliance decision are:Rank Dependent Expected Utility imposes
structure on the translation of probabilitiesProspect Theory translates probabilities,
changes payoff functions, and uses a reference point
Non-Additive Probabilities do not require the normal consistency of aggregation for probabilities
Ambiguity focuses on uncertainty over the probability of outcomes
SOCIAL CUSTOMS
Attitudes to compliance also matter Some taxpayers will always be fully
compliant This can be explained by a social
custom (an informal rule on behaviour) If the social custom is broken there is
an additional loss of utilityU if followed, U – S if broken
S can also be interpreted as a psychological cost of non-compliance
SOCIAL CUSTOMS
Let S = iEi where is the proportion of population who are compliant
Choose either to be compliant with payoff
UNE = U(Y[1 – t]) Or to be non-compliant with payoff UE = E[U] – iEi
People with high i (individual concern about custom) will be compliantCompliantNon-Compliant
0
SOCIAL INTERACTION
How can we explain the formation of attitudes and beliefs?
Both can be the outcome of social interaction
This can be modelled using a social network that governs the interaction between individuals
Individuals meet with their contacts in the network and exchange information
Information affects compliance
SOCIAL NETWORK
A network is a symmetric matrix A of 0s and 1s (bi-directional links)
The network shown is described by
0100
1010
0101
0010
A
1
2
3
4
SOCIAL NETWORK
Social networks can be studied using agent-based models
We have done this to look at audit rules and predictive analytics
Information transmission can sustain a subjective probability above the objective probability
Attitudes can differ among occupational groups
Compliance can be increased by fostering attitudes
CONCLUSIONS
The talk was titled “Understanding individual tax compliance”
When viewed as an individual decision the orthodox model makes incorrect predictions
More accurate predictions can be made by understanding compliance as a social decision
We need to take into account attitudes, beliefs, and opportunities
CONCLUSIONS
Occupational choice links with risk aversion to self-select those willing to be non-compliant into a position where non-compliance is possible
The process of social interaction is central to the formation of attitudes and beliefs
A stronger social custom can give higher compliance
Unknown audit rules force the formation of a subjective probability