There have been many studies of the influences on tax compliance/
non-compliance using audit and compliance experience in different environments. Most have been conducted on federal taxes, particularly the individual and corporate income taxes, but some have been done on major state taxes, particularly the retail sales tax. A review of these studies provides a dozen useful conclusions that can be used in the formulation of tax policy and especially on its administration.
First, as predicted by the compliance lottery view of non-compliance, a higher tax audit rate does improve the rate of compliance. This has been demonstrated in both sales and income tax studies. However, the relationship between audit coverage and compliance is not linear; that is, the return from extra coverage does eventually decline as that coverage gets higher and the impact is not uniform for all taxpayers. The deterrent impact of auditing of individual income tax payments depends upon the income level. Studies have shown that impact is greater for low and middle income class taxpayers (Beron, Tauchen, and Witte, 1992; Dubin and Wilde, 1988). Similarly, the threat of an audit has a positive impact on the compliance behavior of low and middle income class taxpayers but engenders a ‘‘perverse’’ reaction by high-income taxpayers, as found in a compliance strategy experiment in Minnesota (Slemrod, Blumenthal and Christian, 2001). Whether the experience of a prior audit changes the reporting behavior of the individual and induces him to report the true amount of income also depends upon how large the assessment of the previous audit has been. The larger assessments translate into more substantial improvements in compliance (Erard, 1992). However, other characteristics of the taxpayer, like age, level of income and type of the return required to file, blurs the positive effects of prior audit on sub- sequent reporting behavior. Compliance rates among small-business owners depend largely on the perceived risk of getting audited (Beron et al., 1992;
Witte and Woodbury, 1985). The analyses based on aggregated data consistently confirm that higher audit rates improve compliance signifi- cantly, except non-filing (Dubin, Graetz and Wilde, 1990; Plumley, 2002).
Though research on the effects of audits on other taxes is scarce, it also supports results reached in income tax area. Mikesell estimated the impact of audit coverage on the sales tax base per capita. The results indicated that an increase in audit coverage of one percent would lead to a tax base higher by 0.07 percent (Mikesell, 1985). Because Mikesell subtracted direct audit recovery in his analysis, the impact is entirely from induced compliance. On the other hand, research on sales tax compliance
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in Tennessee and New Mexico finds non-compliance to be driven by the opportunity for evasion (complexity) and not by audit coverage itself (Blackwell, Alm and McKee, 2001; Murray, 1995).
Second, again as predicted by the compliance lottery view, higher penalties do yield improved compliance rates. However, the impact is relatively modest. In terms of relative impact, the effect of audit rates is considerably greater than the impact of increased penalties. First, govern- ments face obvious political and social constraints in setting penalties high (Andreoni, Erard and Feinstein, 1998). Second, for the penalties to be credible the changes in penalty level should be accompanied by higher probability of detection. If the probability of detection is small, large responses to changes in the fine rate would require extreme degrees of risk aversion, following the lottery view of compliance. When audit rates and penalty rates are set close to those that are observed in reality, their effects on compliance are not large (Alm, Jackson and McKee, 1992). With high rates of detection even mild penalties can be an effective deter- rent (Hessing, Elfers Robben, and Webley, 1992). The strength of the relationship between the severity of sanctions and compliance depends also upon the audit class. For certain groups of taxpayers — those who have high incomes and are self-employed — the effects of penalties on compliance are significant (Witte and Woodbury, 1985). On the other hand, both higher audit rates and higher penalties may simply induce tax payers to conceal the true income in harder to detect ways (Cowell, 1990; Long and Swingen, 1991).
Third, the indirect revenue effects (deterrence, changed attitudes, etc.,) of audit and other enforcement activities is considerably greater than the direct effect (the collections directly from the action). The latest study done by IRS using state-level aggregate data over a ten year time period (tax years 1982–1991) found that the average indirect effect of audits started in 1991 was about 11.7 times as large as the average adjustment directly proposed by audits closed that year (Plumley, 2002).
This means that resource allocation decisions — audit selection, nonfiler discovery, delinquency pursuit, etc., — based on direct collections from the activity may well not be consistent with the objective of achieving best compliance. For example, certain types of business operate in areas of great tax complexity and, as a result, are likely to generate substantial audit discoveries. However, audit of these businesses, while rich in audit findings, provides no deterrence or changed attitudes for similar businesses or even for the audited business; the nature of the business will create tax issues, even if the business intends to be compliant. Audits elsewhere, although less rich in audit findings, are likely to have considerably greater indirect revenue effect and to make a greater contribution to the
overall compliance objective. Focusing of direct enforcement revenue can hinder achievement of desired tax compliance.
Analysts often speculate on whether a standard for optimal level of tax enforcement should be based on the idea ‘‘that a government should increase spending until the marginal dollar of expenditure produces just over a dollar of additional revenue’’ (Wetzler, 1991). But the direct revenue generated by properly designed enforcement activities like audit should be dwarfed by the indirect voluntary compliance impacts from that work.
Narrow analysis of fiscal impacts — like comparing the costs of putting an extra auditor in the field with the audit recovery from that auditor — provides little helpful guidance about appropriate staffing or other resource allocation. For taxpayer active taxes, the real yield will always be in induced voluntary compliance, not direct short-term revenue recovery.
Because so much of the total effect of audit is through the indirect deterrence effect, it is crucial that tax administrations publicize their audit activities and make the public aware of programs to increase audit activity, whether through hiring new auditors or through redeployment of the existing audit force. It is the potential of audit, not the audit itself, that brings the greatest overall tax compliance and that potential must be broadcast well beyond the taxpayers who are actually selected for audit.
Fourth, though the impact of the marginal rate on the reported income is ambiguous in the basic economic model of compliance, higher tax rates generally reduce compliance. The simple explanation is that a higher tax rate increases the incentive to evade tax. The effects of the tax rate on compliance vary by the audit class, based on the level and source of income. The elasticities of underreporting with respect to marginal rates vary from 0.515 for non-farm businesses to 0.844 for non-business returns.
This means that, for a taxpayer with a combined federal and state income tax marginal rate of 0.40, which is sample average, 10 percent decline in tax rate to 0.36 would result in an expected 5 percent to 8 percent decline in underreported income (Clotfelter 1983: 368). Later studies also point out that a higher rate is associated with lower compliance. In an experimental study, Alm, Jackson and McKee (1992) find that underreported income increases with higher marginal rates with a tax rate elasticity of 0.5, roughly confirming Clotfelter’s result. Higher rates induce more individuals to move into sectors where detection is more difficult or even to the shadow economy, thus aggravating overall evasion problem (Jung, Snow, and Trandel, 1994). Agha and Haughton estimate that a revenue-maximizing VAT rate should not exceed 24.7 percent, given the initial compliance rate of 100 percent. However, with a more realistic initial compliance of 70 percent, the revenue-maximizing VAT is just 19.6 percent (Agha and Haughton, 1996).
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There is a strong positive correlation between income and tax rates, and independent effects of tax rates and income are not easy to disentan- gle in empirical analysis when both these variables are included. However, both higher income and higher tax rates generally are associated with tax evasion. The effects of marginal tax rate at $15,000 taxable income on the net income reported is positive, while the effect of tax rate at the income level of $57,000 and higher is negative (Plumley, 2002). This seems to support the rational actor framework of tax compliance. As tax rate goes up, the rewards for tax evasion goes up, while the penalty of getting caught stays unchanged. This is also consistent with empirical evidence that income is positively correlated with evasion (Forest and Sheffrin, 2002). The elasticity of expected underreporting to income varies by the source of income, from 0.292 for non-business returns to 0.656 for farm income returns (Clotfelter, 1983). However, reducing tax rates will not necessarily induce greater compliance because, once taxpayers have fallen into a pattern of non-compliance, it is difficult to stop. Paying no tax is even more profitable than paying low tax.
Fifth, complexity reduces compliance. There is a general consensus that American income tax preparation is burdensome and even overwhelming.
‘‘A law that can be understood (if at all) only by a tiny priesthood of lawyers and accountants is subject to popular suspicion. By undermining popular support, complexity undermines the self-assessment on which economical compliance depends’’ (Long and Swingen, 1991, p. 640). In support of this complexity claim is the fact that about half of all individual tax returns are made out by paid preparers, and as many as two-thirds of the long 1040 forms are filed with assistance of paid preparers (Erard, 1993).
There can be several causal directions from complexity to non- compliance. Slemrod (1989) hypothesized that complexity increases cost of compliance and therefore increases noncompliance. The research con- ducted by Tax Foundation estimates that it costs individuals and businesses
$125 billion annually to comply with the federal income tax. This converts into 12 cents per dollar collected (Guttman, 2000). Presumably, the less burdensome and costly compliance is, the more likely a taxpayer is to comply with the tax laws.
Complexity can also frustrate taxpayers in their efforts to comply with tax laws and create a sense of unfairness. Technical complexity and the demands for legal completeness produce significant alienation of taxpay- ers leading to lower tax morale and consequently evasion (Vogel, 1974).
Even if taxpayers do not necessarily view a complex tax system as unfair, the requirement to file a long tax form creates opportunities to evade and negatively effect compliance rates of the taxpayers facing such an obliga- tion (Forest and Sheffrin, 2002).
There is a great variety of instruments for law designers to choose from that contribute to tax complexity. One of them is an option between having a single tax rate or multiple tax rates applied depending upon a transaction. Multiple rates are often justified on the equity grounds.
However, it has been found that an additional tax rate in a VAT law increases tax evasion by 7 percent, undermining the equity goals (Agha and Haughton, 1996).
Higher reliance on paid preparers reduces compliance. On the one hand, tax practitioners help alleviate the compliance burden by providing specialized information and computational skills. The use of paid help to file the tax return reduces time and anxiety costs, and uncertainty related with compliance (Erard, 1993). On the other hand, this expertise may be used to exploit gray areas in tax rules to the detriment of compliance with negative consequences for tax equity and efficiency. Klepper, Mark and Nagin have found that where there is no ambiguity in tax code the use of tax preparers promotes tax compliance, however higher ambiguity is related to greater non-compliance (Klepper, Mark and Nagin, 1991).
Tax practitioners are not a homogenous group. Impact of their services on tax compliance depends upon the kinds of services tax preparers provide and upon their characteristics. Some argue that the constraints put on tax preparers by increasingly stringent legislation regulating their profession, and the threat of a potential liability brought upon them by taxpayers for inadequate advice, put some preparers of income tax returns in the position ‘‘of acting as gatekeepers for compliance’’(Dellinger, 1995). If some tax preparers exercise a cautious approach in their counsel others are less scrupulous. The estimates show that noncompliance is 4.5 times larger when tax returns are prepared with the help of a Certified Public Accountant (CPA) or lawyer than it would be if the returns were self-prepared.
Noncompliance on returns prepared by other types of tax practitioners is 15 percent larger than on self-prepared returns. This confirms the survey results that CPAs and lawyers are more aggressive in their practice of tax return preparation than other types of paid preparers.8 For each mode of tax preparation the frequency of noncompliance rises with income and the complexity of the return. The level of noncompliance though is highest for the returns prepared by CPAs and lawyers (Erard, 1993).
As to the characteristics of the taxpayers who choose to hire tax practitioners, it has been determined that income, age, marriage, self- employment and return complexity are among the factors positively related to the decision to hire a tax expert. Also higher marginal rates and higher audit and penalty rates lead to a more frequent use of tax professionals (Erard, 1993). It is the source of income rather than level of income that determines the use of CPA, lawyer or another practitioner over self- preparation. Hiring a CPA or lawyer is attractive to taxpayers with particular
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complex returns and high marginal tax rates. Plumley (2002) also finds significant negative relationship between the use of tax preparers and compliance using aggregate data.
Sixth, compliance improves when taxpayers believe the tax system is fair, when they receive something valuable for their payments and when society shows no tolerance for tax evasion. This finding is explained by a broad concept of ‘‘the tax culture.’’ Because the compliance as lottery does not account well for the level of actual reporting, researchers have proposed prevailing social norms as an important determinant of overall compliance behavior (Alm, 2001; Andreoni et al., 1998). According to Nerre
‘‘tax culture emerges from the tradition of taxation (e.g., an accentuation of [in-] direct taxes) on the one hand and by the interaction of the actors and the cultural values like honesty, justice, or sense of duty on the other hand’’ (Nerre, 2001, p. 288). Major actors forming tax culture are the gov- ernment (legislature), tax authority, taxpayers, academics (experts).
Tax culture is embedded in national culture and is evolutionary, although it is difficult to model and test. There are attempts to include the ‘‘social norm’’ into the basic economic model of tax compliance (Alm and Martinez- Vazquez, 2003) and to adopt game theory approach for the analysis of the evolutionary nature of the interaction between tax officials and taxpay- ers (Nerre, 2002). The majority of the research on tax culture is based on surveys and experiments.
Attitudes about the effectiveness of tax administration and by extension
‘‘the government’’ play an important role in compliance behavior (Alm and Martinez-Vazquez, 2003). The convention to demonize IRS by the politi- cians running an election campaign further augments such perceptions. In the recent debates over tax simplification, advocates of the ‘‘flat tax’’ such as Senator Robert Dole or candidate Steve Forbes claimed that it would eliminate the IRS as Americans currently know it (Alvarez and Brehm, 1998).
Though taxpayers often do not distinguish between the fairness of tax system and the ‘‘procedural fairness’’ of the IRS, both perceptions form attitudes that translate into taxpaying behavior. Comparative analysis of different tax cultures indicates that increased enforcement efforts are less effective where the tax regime is viewed as unfair. The motivation for that kind of evasion is the need to compensate for the psychological loss in expected income because of — from a tax cultural view — ‘‘excessive’’
tax payments (Nerre, 2002; Vogel, 1974). Additionally, Forest and Sheffrin (2002) find that taxpayers who believe that they do not receive adequate public goods for their tax payments deem the system to be unfair and are more likely to evade taxes. Brosio and Cassone (1999) find that tax evasion is higher in those Italian regions where the quality of provided public services is lower.
Tolerance for tax evasion breeds more evasion. A high level of evasion puts a pressure on otherwise ‘‘law-abiding citizens’’ to compensate for the additional burden of taxes, creating a tendency to tax evasion even among honest taxpayers (Vogel, 1974). People living in areas where a large num- ber of taxpayers willfully and sometimes successfully ignore efforts of the collecting agency, e.g., delinquent account notices, tend to be less compliant than those living in areas where response to tax administration efforts is quick and positive (Witte and Woodbury, 1985). Higher compliance is associated with low social standing of evaders, viewing tax evasion as
‘‘immoral’’ by an individual, and a stronger sense of social cohesion (Alm and Martinez-Vazquez, 2003).
Direct democracy arguably improves the dialog between the taxpayer and the government through a greater participation in decision process, leading to a fairer tax system and less evasion as found in a research based on the U.S. and Switzerland data (Torgler, 2002). Rising income inequality contributes to the taxpayer stress through financial strain on the lower end of the spectrum and through reduced visibility of transactions, as the wage income declines as a percentage of total income, on the higher end of the spectrum. As a result, the dissatisfaction with the tax system grows and tax compliance deteriorates as an analysis of the U.S. wage and salary data for the period 1947–1999 indicates (Bloomquist, 2003).
However, direct appeals to taxpayer social duty have only limited positive effects on compliance. An appeal that the correct payment of taxes is essential for the provision of valuable public services had a positive effect only on one taxpayer group, namely homeowners (Blumenthal, Charles and Slemrod, 2001). Overall results of the research suggest the policies are more successful if they are designed to target specific taxpayer groups. Notices sent out to taxpayers with delinquent accounts are associated with higher levels of compliance, with elasticities ranging from 0.02 for both small proprietors and upper income self-employed individuals to 0.01 for middle income wage and salary workers (Witte and Woodbury, 1985). Quite a few state revenue departments have made the list of delinquent taxpayers public on the Internet. Such programs should have an effect of reinforcing social norms of tax compliance by exposing the deviant behavior. Whether such compliance strategies are effective deterrents has not been empirically evaluated yet.
So-called ‘‘internal norms’’ that define how an individual understands what is a proper, acceptable or moral behavior are probably harder to influence than the ‘‘external norms,’’ like perceptions about the fairness of the tax burden, government’s performance in such areas as tax collection and provision of services (Alm and Martinez-Vazquez, 2003). Taxpayers who regard tax evasion as immoral are less likely to evade taxes regardless
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