Far from being rational actors, able to make decisions in their own best interests, research is increasingly demonstrating that people exhibit predictable biases that make it less likely that they will achieve their own stated desires (Thaler and Sunstein, 2009). This can complicate the design and efficiency of policy broadly and tax and transfer policy in particular. But knowledge about these biases can be used to better design policy.
Behavioural Insights or BI can be grouped into a number of related findings. One of the most valuable insights relates to bounded rationality and heuristics (Kahneman, 2011). In particular, individuals do not make the perfect decision but a good enough decision. This is exacerbated by issues of complexity, scarcity and cognitive load where poverty and/or financial stress increases the cost of bad decisions and makes them more likely (Mullainathan and Shafir, 2013). Loss aversion and the endowment effect relate to the consistent finding that individuals care more about what they lose than what they gain (Camerer and Loewenstein, 2004). And they care about when those losses and gains occur. Hyperbolic discounting reminds individuals that they care about the present over the future, a lot (Frederick et al., 2002).
One of the sets of BI that has strong implications for tax policy relates to framing and construal (Mullainathan and Shafir, 2013). Individuals make decisions based on how the world appears, not how it is. And this includes how they think about themselves. There is a large body of research around identity, social norms and fairness that shows that individuals care about how they see themselves and how others see them, and they care about how much others have, not just how much they have (Mullainathan, 2007; Akerlof and Kranton, 2010).
To date, the majority of behavioural research in the area of tax compliance has focused on income tax, and in particular, individual taxpayers. However, recent work has shown that behavioural insights have a significant role in improving the compliance of small and medium enterprises (SMEs): research has expanded into understanding how SMEs deal with various tax type obligations, such as value-added-taxes (VAT) or pay-as-you-go employee obligations.
Tax non-compliance includes both illegal practices such as failing to report full earnings, or reporting false deduction (these illegal practices are known as tax evasion), as well as the legal minimisation achieved by taking advantage of tax loopholes and tax schemes (these legal practices are known as tax avoidance). As Alm (2014) explains, unlike employees whose tax obligations are automatically deducted each pay period, SMEs are as a group, at a higher risk of employing both forms of non-compliance, and so are a highly relevant group for tax collectors to target. We can build on the general BI findings cited above to help us understand and improve the tax compliance of SMEs.
Tax morale and business culture matter
We usually associate tax morale – the intrinsic motivation to pay taxes – with individual taxpayers. Yet this concept can also be extended to SMEs. Alm and McClellan (2012) undertook an international study of 8,000 firms to derive a measure of tax morale. They find that as with individuals, firm tax morale has a positive and significant effect on tax compliance, and that it can be undermined by factors related to governmental influences, including perceived levels of government corruption. Interestingly, as with individual taxpayers, monetising the process of compliance for businesses decreases tax morale and compliance. For example, Gangl et al. (2014) find that tight supervision of newly established firms crowded out timely payments of tax obligations. Hence, promoting tax morale and a taxpaying culture is as important as implementing traditional deterrence techniques such as monetary penalties.
Tax accountants influence compliance behaviour
Using data from self-reported surveys, Tan et al. (2014) find that business compliance is highly susceptible to the recommendations of tax accountants. More importantly, businesses often commit to tax accountants who provide aggressive tax planning advice, regardless of the businesses deeming the tax advice competent or the tax accountant trustworthy. Given that tax accountants have a powerful influence on compliance behaviour, their roles and incentives must be accounted for in developing better tax policies.
A tax system that is service-driven and easy to navigate generates compliance
Tax collectors have traditionally used strict mechanisms, such as high monetary penalties, to deal with evading taxpayers. However, these tactics do not only fail to address prevalent tax avoidance practices but also to generate a significant increase in compliance. Tax systems, including the Australian Taxation Office (ATO), now employ a service-driven approach to inculcate a taxpaying culture. Beers et al. (2013) conducted a study of SMEs, finding that the treatment of taxpayers in the tax process had a major impact on compliant behaviour.
A service-driven approach is also important in generating business compliance given the increasing complexity of tax systems. SMEs face high compliance costs, and there is recent evidence that an unfriendly service provision increases the compliance burden of firms and decreases tax morale, particularly for the smaller firms. Another study also shows that increasing complexity leads firm owners to make more mistakes when filing taxes, and, on the collectors’ side, mistakes in more complex systems are harder to detect. Hence, attempts to make the taxpaying process friendlier and simpler not only benefit individual taxpayers, but also enterprises whose tax obligations are often much more complex and burdensome.
Payment capacity should be emphasised early in the earnings cycle
Although businesses may intend to comply, they may not always have the capacity to do so, especially in highly complex tax systems. For this reason, tax collectors are increasingly emphasising an integrated compliance strategy that promotes compliance from the early stages of the taxation process.
Evidence from a New Zealand study shows that by using analytics to identify businesses at risk of non-compliance, and subsequently employing educational programs on compliance as well as providing flexible payment arrangements, voluntary compliance substantially improved. The study also revealed that two thirds of participating firms were unaware of already-established policies that help businesses that have fallen behind payments to get back on track without penalties.
Young enterprises require the most support given the financial difficulties they face in early years of operation, and the lack of knowledge of business tax obligations. The benefits of early interventions for new businesses have an additional benefit: young entrepreneurs and businesses have more malleable norms, and can thereby more easily acquire a tax-paying culture.
Early interventions to promote compliance can ensure that many more businesses have the capacity to make timely payments, while reducing the costs of tax collectors who must chase after non-compliant taxpayers.
In recent years, we have witnessed an explosion of tax compliance research that relies on BI to explain how compliance comes about, as well as how it can be improved. Yet it is misleading to think of these insights as employing a single, homogenous strategy. Differences in the methodological approaches and scope of tax type and taxpayer from which these insights stem, are crucial in understanding their advantages and limitations. In this way, research on the tax compliance of SMEs that recognises the heterogeneous mix of taxpayers and tax types, presents an important attempt to make research findings more readily applicable to the process of implementing better tax policies.
References
Akerlof, G. A. and R. E. Kranton (2010). Identity Economics: How Our Identities Shape Our Work, Wages, and Well-Being, Princeton University Press.
Alm, J. (2014). Expanding the theory of tax compliance from individual to group motivations. In Forte, F., Mudambi, R., & Navarra, P. M. (Eds.), A Handbook of Alternative Theories of Public Economics, 260-278. Edward Elgar Publishing.
Alm, J. and McClellan, C. (2012). Tax Morale and Tax Compliance from the Firm’s Perspective, KYKLOS 65(1), 1-17.
Beers, T., Nestor, M., & San Juan, E. (2013). Small Business Compliance Further Analysis of Influential Factors. National Taxpayer Advocate.
Camerer, C. F. and G. Loewenstein (2004). Behavioral Economics: Past, Present, and Future in Advances in Behavioral Economics, in: C. F. Camerer, G. Loewenstein and M. Rabin (eds.), Advances in Behavioral Economics. New York Russell Sage.
Frederick, S., G. Loewenstein and T. O’Donoghue (2002). Time Discounting and Time Preference: A Critical Review, Journal of Economic Literature 40(2), 351-401.
Gangl, K., Torgler, B., Kirchler, E., and E. Hofmann (2014). Effects of Supervision on Tax Compliance: Evidence from a Field Experiment in Austria, Economics Letters 123(3), 378-382.
Kahneman, D. (2011). Thinking, Fast and Slow. Macmillan.
Mullainathan, S. (2007). Psychology and Development Economics, in: P. Diamond and H. Vartiainen (eds.): Behavioral Economics and Its Applications. Princeton, Princeton University Press.
Mullainathan, S. and E. Shafir (2013a). Decision Making and Policy in Contexts of Poverty, in: E. Sharif (ed.): The Behavioral Foundations of Public Policy, pp. 281-300.
Tan, L. M., Braithwaite, V., M. Reinhart (2014). Why Do Small Business Taxpayers Stay with their Practitioners? Trust, Competence and Aggressive Advice, International Small Business Journal, 1-16.
Thaler, R. H. and C. R. Sunstein (2009). Nudge: Improving Decisions about Health, Wealth, and Happiness, New York: Penguin Books.
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