Standard deterrence theory and Tax reform

Standard deterrence theory indicates that tax compliance can be improved by raising the expected monetary cost of evasion for taxpayers. People may choose to obey or violate the law after calculating the gains and consequences of their actions. The expected cost is a simple function of the probability of detection and the fine for evasion. For example, a rational person would not evade Tk100 of taxes if he had a 50% chance of incurring a Tk400 penalty (expected penalty of Tk200) or a 5% chance of incurring a penalty of Tk4, 000. Thus, according to deterrence theory, policymakers should be able to reduce tax evasion by raising the frequency of audit, increasing tax penalties, and some combination of both.

It is puzzling why the government has not employed this seemingly obvious strategy. The answer is simple, because it is not necessarily cost-effective from the government's perspective. Increasing tax penalties impose more subtle costs, but many scholars' arguing that increasing penalties much beyond their current level is cost prohibitive due to both high administrative costs (such as increased litigation) and the potential 'crowding out' of voluntary compliance.
But there is another cost of tax evasion incurred by taxpayers, which may provide a more promising means for the government to improve tax compliance. Apart from the potential monetary costs, individuals may also experience some form of psychological discomfort when they are dishonest, which may deter them from evading tax. This discomfort imposes an additional utility cost not accounted for the standard deterrence model. This is known as the 'psychic cost' of tax evasion, and it should be factored into our understanding of the taxpayer's cost-benefit analysis along with the monetary costs.

Recent empirical studies by psychologists and behavioral economists, however, have demonstrated that individual honesty is actually a malleable trait influenced heavily by environmental factors. While a few individuals are completely honest in all circumstances (even if it would be economically advantageous to lie), and a minority of individuals are dishonest whenever it financially benefits them, most fall somewhere in the middle of the spectrum and may or may not evade tax depending on the circumstances.

A taxpayer who is deciding whether to comply with the tax law will weigh the expected cost of tax evasion against the cost of complying and choose the cheaper option. The cost of complying is simply the amount of tax owed. A policymaker seeking to deter a rational taxpayer from evading tax can do so by raising the expected cost of evasion, with the goal of making it more expensive than the cost of compliance. It follows from the model that raising either the probability of detection or the penalty for evasion, or some combination of the two, can increase the expected cost of evasion. In the context of tax compliance, this means higher tax penalties, raising the frequency of audit, or finding some other method to increase the rate of detection. The standard deterrence model provides a powerful mechanism by which the government can improve compliance, namely, by making evasion more costly for the taxpayer.

The scope for nonmonetary punishment is relatively limited in developing countries. Nonmonetary punishment schemes including imprisonment for tax evasion assumingly has added importance. If the possibility of imprisonment is credible enough, it might affect the behavior of taxpayer without other option. A credible possibility of imprisonment, not the actual imprisonment, is important for taxpayers' behavior. Thus from a policy perspective, the threat of imprisonment seems to be an attractive instrument to improve taxpayer compliance in developing countries.
However, the effects of higher punishment depend on the extent of corruption in tax administration. If most of the tax officials are corrupt, a higher punishment can make things worse for both the taxpayers and government. Since the possibility of imprisonment increases the bargaining power of tax official's vis-a-vis the taxpayer, the bribe amount will in general increase. But this may not increase government revenue as the officials gets rich at the expense of both taxpayers and the government. A statute or real tiger in the tax office premise will not change the mind of taxpayers.
Imprisonment is a fundamentally different form of punishment that entails potential loss of reputation in the society for the family of a tax evader in addition to the cost of evasion. Because of this special nature of imprisonment as a punishment for tax evasion, it stood out as the salient feature of the tax reform. Furthermore, given that increased monetary punishment for tax evasion was in the form of higher interest rates on arrears and surcharges.

Tax administration and compliance have long been the weakest links in tax reform in developing countries. In the last few decades, significant tax reform has been implemented in a large number of developing countries under the structural adjustment and stabilization programs of the World Bank and International Monetary Fund (IMF). The focus of the reform has been, however, on the tax structure, i.e., tax bases and rates, most notably on introducing Value-Added Tax (VAT) and reducing custom tariff. The discretionary power of tax officials remains unchanged. Although most of the tax reform programs include some administrative components, they are usually accorded with only a supportive role at best. The widely implemented tax reform program in Bangladesh that instituted VAT as a main source of government revenue has created resentment among the business community due to cascading effect and over burden on existing taxpayers. The large sector of taxpayers is out of tax net.

Policymakers may design alternative regulatory policies to encourage tax compliance fall into three main categories, each consistent with one of the three paradigms: increase the likelihood and the possibility of punishment, improve the provision of tax services with widening tax net, and change the tax culture within the revenue department. First, there is scope for an improvement in regulatory policies to increase detection and punishment for both tax evader and supporting tax officials.

Traditionally, there are three main aspects of tax administration: taxpayer registration, taxpayer audit, and collections. Improvements in each of these areas are feasible, all of which would enhance detection and punishment, for example, imposing interest and fines for late reporting. Government may increase number of tax officials and specially increase the number of audits, by hiring additional auditors or by contracting out audits to for-profit firms, improve quality of audits and auditors. Improve information sharing across governments departments and financial institutions, which use to deduct advance income tax and VAT and increase penalties for tax evading through the interest rate on unpaid taxes.

Impose of mandatory registration and identification for different economic activities via better use of third-party information, such as use of cross-referencing between different taxes (e.g., checking VAT against income tax returns for both input and finished products) or use of social security records, phone records, bank transaction, and data of properties and vehicle ownership, overseas travel etc. In addition to these somewhat standard suggestions, tax administrations might consider actions like disallowing cash deductions unless the taxpayer identifies the person or firm that was paid, requiring increased information from selected taxpayers, and expanding source withholding or collection of advance income tax.

Second, there is scope for an improvement in the services of the tax administration by becoming more 'consumer-friendly', along the lines of the 'service paradigm' by promoting taxpayer education, providing taxpayer services to assist taxpayers in filing returns and paying taxes, simplifying taxes and easy payment system. There may be scope for a government-induced change in the culture of paying taxes, consistent with the 'trust paradigm'. The government may use mass media to reinforce tax compliance as the ethical form of behavior and publicize evaders.  
Government may target certain groups (e.g., new firms or employees) in order to introduce from the start the notion that paying taxes is 'the right thing to do'. The government may employ other organizations from private sector to promote compliance, so that it is seen that paying taxes is the accepted and ethical pattern of behavior.  The basic thrust of these 'service paradigm' actions is to treat the taxpayer more as a client than as a potential criminal. The tiger place in the premise of National Board of Revenue (NBR) may be used to accelerate reform in NBR and punish corrupt officials. More importantly, a policy, which emphasizes for link between payment of taxes and the receipt of government services, is essential.

The writer is a legal economist

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