Monday, January 2, 2012

Tax morale and compliance:review of evidence and case studies for Europe

Adams‘ book (1993) begins with the inscription found over the entrance to the Internal Revenue Service building: ―Taxes are what we pay for a civilized society‖. An essential question for policymakers is the extent to which individuals are willing to pay this price. The state-building process in post-communist societies and state-maintaining element requires the collection and the use of revenues. 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. 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 to inform the analysis of individual and group decision making. This report represents an attempt to review exactly this new framework of 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. In general, the effect of cultural or social norms and of social capital on tax compliance behavior is not well understood and addressing this gap is the focus of the present research report.

It is useful from 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 Becker‘s (1968) economics-of-crime model first applied to tax compliance by Allingham and Sandmo (1972). Here a rational individual is viewed as maximizing the expected utility of the tax evasion gamble, by weighing the benefits of successful cheating against the  risky prospect of detection and punishment. Through this process, an outcome is reached where the individual pays taxes because he or she is afraid of getting caught and  penalized if he or she does not report all income.

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 result: individuals focus exclusively on the financial incentives of the evasion gamble, and individuals pay taxes  solely because they fear detection and punishment.

World Bank.Author:Torgler,Benno; Document Date:2011/12/01. Document Type:Policy Research Working Paper.Report Number:WPS5922