IREF - Institute for Research in Economic and Fiscal issues
Für wirtschaftliche Freiheit und Steuerwettbewerb
The traditional literature on tax evasion frames taxpayers’ choices in terms of rather basic cost-benefit analyses involving the expected monetary return to tax evasion. Briefly put, individuals take action by taking into account the probability of being caught and the sanctions applied.
In contrast with the mainstream line of thinking, this paper considers what happens when
(1) tax compliance is considered a duty only if tax revenues are not wasted (bad-quality government expenditure);
(2) assessing the probability of being detected and the punishment involved is actually a learning process, which unfolds by interacting with other people, both tax evaders and tax compliers;
(3) being found guilty of tax evasion implies a loss of reputation and a social stigma;
(4) the reputational effects of auditing depends on the typical behavior of a society (i.e. the social stigma is larger if an individual is found guilty in a society in which most citizens pay taxes honestly).
The theoretical context presented in this paper shows that when social interaction and stigma play a relevant role, the tax authorities can reach a much higher level of tax compliance by reducing the tax burden and progressivity, and by simplifying the tax system. By contrast, the most frequently used measure to enforce compliance (increased auditing effort and heavier sanctions) can be counterproductive. The paper therefore provides a possible theoretical framework that helps explaining some of the results created in Russia by the 2001 tax reform.
Importantly, a reduction of the tax burden and progressivity may have positive effects on tax compliance both in the short (i.e. tax evasion is expected to decrease once the tax burden is reduced) and in the long run (i.e. tax evasion is expected to keep decreasing in the years following the tax reform). The paper describes the possible long run effects, including some rather extreme situations, that a tax reform may have on the long run level of tax evasion.
Finally, the paper shows that creating and nurturing an honest reputation may have positive effects on tax compliance without the financial and political costs of creating a moral stigma against dishonest payers.