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