Friday, March 19, 2010

Nudging on tax compliance - evidence from an RCT

A fascinating recent NBER working paper by Henrik J. Kleven, Martin B. Knudsen, Claus T. Kreiner, Søren Pedersen, and Emmanuel Saez explains the results of a randomized tax enforcement experiment conducted in Denmark for a stratified and representative sample of over 40,000 individual income tax filers. The study has interesting findings on increasing tax compliance.

In the first stage (year), taxpayers were randomly selected for unannounced comprehensive (both third-party reported and self-reported incomes) tax audits of tax returns filed in 2007, and any detected misreporting was corrected and penalized as appropriate according to Danish law. For the second half of taxpayers not selected for these audits, tax returns were not examined under any circumstances. In the second stage, employees in both the audit and no-audit groups were randomly selected for pre-announced tax audits of tax returns filed in 2008. One group of taxpayers received a letter telling them that their return would certainly be audited, another group received a letter telling them that half of everyone in their group would be audited, while a third group received no letter.



Their model predicts that evasion will be low for third-party reported income items, but substantial for self-reported income items and that the effects of tax enforcement (audits, penalties) and tax policy (marginal tax rates) on evasion will be larger for self-reported income than for third-party reported income. They have four main findings

"First, we find that the tax evasion rate is very small (0.3%) for income subject to third-party reporting, but substantial (37%) for self-reported income... Second, using bunching evidence around large and salient kink points of the nonlinear income tax schedule, we find that marginal tax rates have a positive impact on tax evasion, but that this effect is small in comparison to avoidance responses. This suggests that rigorous tax enforcement is a much more effective tool to combat tax evasion than lowering marginal tax rates. Third, we find that prior audits substantially increase self-reported income, implying that individuals update their beliefs about detection probability based on experiencing an audit. Fourth, threat-of-audit letters also have a significant effect on self-reported income, and the size of this effect depends positively on the audit probability expressed in the letter."


This is a classic example of how the behavioural aspects of tax payment decision making plays a critical role in determining compliance rates. In the aforementioned example, both prior audits and even the mere threat of an audit substantially raised compliance rates. Tax authorities in India would do well to embrace atleast the idea of sending "threat of audit" letters randomly to a targetted group of potential tax evaders (and follow it up with actual audits and enforcement action), so as to nudge them into minimizing their income under-reporting.

And this also carries a strong message to those consistently advocating lowering the marginal tax rates on the grounds that it will improve compliance. Contrary to conventional wisdom - expemlified by the now infamous Laffer curve of the Reagan era tax cuts in the US - that highlights the positive impact of lowering marginal tax rates to increase compliance, the aforementioned study finds that the marginal tax rates have only modest effects on tax evasion and are dwarfed by the third-party reporting effects. In any case, advocates of cutting marginal tax rates have always ignored the fact that the Laffer curve itself has an upward sloping first half!

Note : Third-party information reporting refers to the institutions such as employers, banks, investment funds, and pension funds directly reporting taxable income earned by individuals (employees or clients) to the government. Under this system, the overall tax evasion is low not because taxpayers are unwilling to cheat, but because they are unable to cheat successfully due to the widespread use of third-party reporting.

1 comment:

Orphe said...

Care to view the following video and comment on your blog? your opinion matters!

http://www.freedomandprosperity.org/videos/laffercurve1-3/laffercurve1-3.shtml