How can govts effectively improve tax compliance?

Sanctions, fines and even prison sentences, do not constitute intrinsic motivation for complying with tax laws, which should arguably be the objective.

There are other more appealing methods, as some researchers from Tulane University in the US, and the Walter Eucken Institute in Freiburg, Germany, have been investigating.  

Their comprehensive survey on current developments in tax compliance research shows that the effects of deterrence are more nuanced than initially thought. Interventions that complement sanctions can improve tax compliance. 

Nudge and sludge

They start with the effects of 'nudges' that alter the ways in which the choices facing individuals are communicated to them by the tax administration.

Nudge interventions can be used to explain the benefits of taxation to society as a whole, and also appeal to taxpayers’ intrinsic motivation to pay taxes. Such nudge interventions typically do not require taxpayers to learn new skills or to exert substantial mental effort. 

However, the nudge approach seems to have rather mixed effects on increasing tax compliance, suggesting that the specific design and implementation of these interventions are fundamental to their effectiveness.

Nevertheless, the authors of the study see considerable compliance-inducing potential in nudges that simplify tax-related decisions, or providing better taxpayer services such as presenting tax-related information in a more intuitive and accessible manner, or provide alternative and attractive options.

Policy reform should first and foremost aim to establish effective, transparent, and fair tax systems.

They also extend their discussion to other behavioural economics interventions that have not yet been studied widely in tax compliance research. These include reducing 'sludge', which refers to features in the tax system that make it excessively complicated.

In Germany, the tax system is particularly convoluted and complex, such that tax advisers have become a major and indispensable element of the economy. Yet, various proposals for a simplifying revamp of the tax system have not so far materialised. 

Indeed, my wife and I are both self-employed and literally cannot do our taxes on our own due to the complexity of both our own work structures and the tax system in Germany. 

Our tax adviser told us this years ago in no uncertain terms. Despite being well-educated, the level of knowledge and understanding required to file our taxes is beyond our capabilities.   

Boosting knowledge

Another option is that of 'boosts', which target individual tax-related skills, thereby helping taxpayers to comply with legislation and make better decisions in this context. 

Governments and tax authorities can invest in citizen education to improve knowledge on public finances and the functioning of tax and pension systems, that is, enhance fiscal literacy, which might also increase tax compliance.

This boosting approach requires a more long-term investment and a higher degree of mental effort and engagement on the part of the decision-maker, but is also consistent with a sludge-reducing approach.

Due to their more long-term effects, however, boosts might not be as readily cost-effective as several choice-specific nudge interventions. 

Also, as indicated above, where there is really major sludge, even educated people may not learn enough to help much. Having said that, boosting should still improve economic education and therefore foster tax morale, at least to some extent.

The effects of boosts might thus extend well beyond the effects of nudges.

Boosting fiscal literacy might have the additional benefit of facilitating electoral voting decisions that align more closely with individual preferences and thus result in tax systems that more closely reflect people’s true preferences rather than, for instance, the efforts of lobbying groups.

In sum, boosts may increase willingness to pay taxes outside the narrow decision framework that is affected by nudges. They also have the potential to improve compliance by reducing sludge, or at least its impact.

No silver bullet

Neither nudges nor boosts nor sludge should be expected by themselves to close the compliance gap. Instead, it is important to remember that taxpayers’ compliance decisions are made within an institutional framework, and policy reform should first and foremost aim to establish effective, transparent, and fair tax systems.

This includes the use of tax audits to ensure that taxpayers who are deemed to have a high propensity for cheating pay their fair share. 

However, there is clearly a long way to go for many countries, especially in terms of transparency and perceived or actual fairness.

Additionally, the inherently negative attitudes of some people towards paying taxes are difficult to change. Some of this negativity is understandable considering the complexities that some taxpayers face. 

Boosting should still improve economic education and therefore foster tax morale, at least to some extent.

The central argument of this current research project is that behavioural interventions can and should be utilised in the design of tax policies and the work of tax administrations.

For example, policymakers and tax administrations need to work towards simplifying the tax system and more effectively highlight the social benefits enabled through taxes.

These approaches undoubtedly constitute valuable additions to the toolbox of measures that tax administrations employ to build better tax systems and promote tax compliance. 

However, for the methods to effectively complement traditional deterrence approaches, tax administrations should evaluate them carefully and skilfully before their implementation. 

Furthermore, to effectively convert these insights into practice, tax administrations must be open to partnering with researchers and other individuals or bodies with relevant insights and knowledge, so as to systematically evaluate the potential of novel behavioural approaches for increasing tax compliance. 

Closer co-operation between tax administrators and all relevant stakeholders should thus be facilitated and encouraged.

Brian Bloch is a freelance journalist based in Germany