erich kirchler university of vienna, austria tarc master class london - 2014 tax psychology (3)...
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Erich KirchlerUniversity of Vienna, Austria
TARC Master ClassLondon - 2014
Tax Psychology (3)Decisions under uncertainty
(risk)
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Economics
Ideas of humankind: Homo Oeconomicus
• Utility maximization• Rationality (consistent, goal-oriented behaviour)
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Economics
Utility maximizationRationality assumptions: Axioms
Completeness (a > b; b = c; c > d; ...)
Transitivity (if a > b and b > c, then a > c)
Reflexivity (a = a)
Non-satiation (a + 1 > a)
Continuity (a, b) = (a – x, b + y)
Convexity (Law of Saturation)
Paying taxes as outcome of a decision under risk
Tax rateIncomeAudit probabilityFines
Tax compliance 1
Tax evasion
1 - p
p
No audit
Audit
Net income
Net income + evaded amount
Net income - fine
How to increase and guarantee tax compliance ?Decision under risk
Allingham & Sandmo (1972); Srinivasan (1973)
Becker, G. S. (1968). Crime and punishment: An economic approach. Journal of Political Economy, 76, 169-217.
Sure option
Risky option
Average compliance rate by fine rate and audit probability (standard deviations in parentheses; Alm et al., 1995, p. 11)
Audit Fine rateprobability 1 2 4-----------------------------------------------------------------------------0.05 9.0 ( 4.0) 6.9 ( 3.2) 12.2 ( 4.2)0.30 10.9 ( 6.0) 21.4 ( 4.4) 39.8 ( 7.4)0.60 9.8 ( 8.0) 54.8 (10.6) 70.3 ( 7.5)
What does the theory say about what motivates tax compliance ?
The standard theory of human behaviour is based on several assumptions:• Individuals are rational,• Individuals have unlimited willpower,• Individuals are self-interested.
From James Alm, 2014, Tulane University, USA.
What does the theory say about what motivates tax compliance ?
The starting point: Economics-of-crime model• A rational individual weights the expected benefits of
successful cheating against the risky prospect of detection and punishment.
• The individual pays taxes because he or she is afraid of getting caught and penalized.
• Indeed, the individual pays taxes because – and only because – of the fear of detection and punishment.
Compliance depends upon enforcement.
From James Alm, 2014, Tulane University, USA.
What does the theory say about what motivates tax compliance ?
However, …• Individuals face limits of their ability to compute (e.g., bounded rationality)• They systematically misperceive, or do not perceive at all, the true cost of
their actions (e.g., fiscal illusion, saliency, overweighting of (low) probabilities)
• They face limits of their self-control (e.g., hyperboic discounting; Christmas club savings)
• They are affected by the ways in which choices are framed (e.g., reference points, gains versus losses, loss aversion, risk-seeing behavior)
• They are affected by the social context in which, and the process by which, decisions are made
• They are motivated by notions of fairness, altruism, trust, guilt, shame, morality, alienation, emotions, patriotism, social customs, social norms, tax morale, …
From James Alm, 2014, Tulane University, USA.
What does the theory say about what motivates tax compliance ?
Behavioral economics suggests several main conclusions about what motivates tax compliance:• Enforcement matters – but many other factors matter in
the tax compliance decision beyond enforcement.• An individual does not always behave as assumed in
the standard economic appraoch.• Individuals are social creatures and are influenced by
group considerations.
From James Alm, 2014, Tulane University, USA.
Dan Arieli Cheating16 min
MetaanalysesAndreoni, J., Erard, B., & Feinstein, J. S. (1998). Tax compliance.
Journal of Economic Literature, 36(2), 818-860.
Kirchler, E., Muehlbacher, S., Kastlunger, B. & Wahl, I. (2010). Why pay taxes? A review of tax compliance decisions. In J. Alm, J. Martinez-Vazques & B. Torgler (eds.). Developing Alternative Frameworks for Explaining Tax Compliance (pp. 15-31). London: Routledge.
Most people are honest !
Correlations between tax evasion and measures of psychological instigations and constraints (Elffers et al., 1987)
Behavioural outcome measures
Psychological variables2-year self-
reportDocumented
statusDocumented amount of
tax evaded
Dissatisfaction Dissatisfaction with tax authorities Comprehensibility of rulesPersonality Competitiveness Alienation Tolerance of deviance
Fear of punishmentSocial controlPersonal control (attitudes)
0 + +
0 + +
- 0 0
- 0 0+ 0 0
1. DeterrenceTo protect honest taxpayers from free riders, controls are necessary.
Negative sanctions are necessary at an adequate level and in the proper form, depending on the ability of the tax offender to pay. Tax authorities need to cooperate intensively with legislators, judges, and international authorities.
The effect of deterrence measures is weak and sometimes oppostite to the intended effect…
Enforcing tax compliance
Enforcing tax complianceWhat effect have fines ?What effect have repeated audits ?
A fine is a price !
Gneezy, U. & Rustichini, A. (2000). A fine is a price. Journal of Legal Studies 29(1) 1-18. Experimental group: Managements of 6 day care centers introduced a fine for late pick up of children; Control group: 4 day care centers did not introduce a fine.
Reducing undesirable behavior by special taxes
Australia’s National Tobacco Campaign%
of
smok
ers
cla
ssifi
ed a
s he
avy
smok
ers
(25+
)
May 97 Nov 97 Nov 98 Nov 99 Nov 000
5
10
15
20
25
30
Harmonization of fees in different states
(to end cross-border Evasion of cigarette taxes)
Shift from a weight
to a stick based system
Extra tax on
tobacco products
Scollo, Younie, Wakefield, Freeman, & Icasiano, 2003
Potential side effects of special taxes 1
Australia’s National Tobacco Campaign
May 97 Nov 97 Nov 98 Nov 99 Nov 000
5
10
15
20
25
% o
f sm
oker
s us
ing
Rol
l You
r O
wn
Toba
cco
Scollo, Younie, Wakefield, Freeman, & Icasiano, 2003
Shift towards unhealthy form of tobacco consumption
Potential side effects of special taxes 2 Cigarette sales & consumption in Washington State (USA)
Tax rise from 25c
to 75c per pack
Stehr, 2005
Consumption remains stable
Presumably due to smuggling
Tax compliance(Kirchler, Maciejovsky & Schwarzenberger, 2005)
20
0 1 2 3 4 Base-line Periods following audit
.6
.5
.4
.3
.2
.1
0
Co
mp
lian
ce
Audit probability 30 %
Misperceived
probability &
Loss repair
Robust phenomena: the “bomb crater effect“ and the „echo effect“(Guala & Mittone, 2005; Mittone 2006; Kastlunger et al. 2009; Maciejovsky et al. 2007)
0
100
200
300
400
500
1 7 13 19 25 31 37 43 49 55
4 10 16 22 28 34 40 46 52 58
Tax payments (averages, first group)Value (Italian Liras)
Tax due
Average tax paid
Audit
Round
“Echo” effect in experiments with audits in the first and second half of 60 business periods, respectively Guala and Mittone (2002, p. 12 and 13)
“Echo” effect in experiments with audits in the first and second half of 60 business periods, respectively Guala and Mittone (2002, p. 12 and 13)
0
100
200
300
400
500
1 7 13 19 25 31 37 43 49 55
4 10 16 22 28 34 40 46 52 58
Tax payments (averages, first group)Value (Italian Liras)
Tax due
Average tax paid
Audit
Round
Impact of immediate versus delayed audits on tax compliance and perceived fairness of authorities
Kogler, C., Mittone, L. & Kirchler, E. (2014)
Timing of feedback of tax audits matters– Uncertainty resolution in tax experiments: waiting for an audit increases tax
compliance (Muehlbacher et al., 2012)– Problem: audits directly after filing taxes in most tax experiments, but in reality
often years after filing a tax report (e.g., Austria 5-10 years)
Feedback related to trust, trust related to compliance– In other contexts (e.g., organizational psychology; Sapienza & Korsgaard, 1996)
timeliness of feedback was identified to increase trust and acceptance of decisions
– In tax literature trust in state/authorities was identified as an important determinant of tax compliance and tax morale (e.g., Torgler & Schneider, 2004; Braithwaite & Wenzel, 2007; Kirchler et al., 2008)
Experimental Design
• 22 rounds of taxpaying in a laboratory experiment• Regular income
– 3000 ECU, tax rate: 900 ECU– Pay-off determined at the end (one round randomly chosen)
• Audit probability: 15%– Rounds 3, 12, 21 for all participants to keep effects of audits constant
• Fine in case of detection– 2 x evaded amount (paying back + fine equal to evaded amount)
• Feedback– After each round vs. only at the end (summary after the last round)
• Rounds of reduced earnings– Rounds of reduced earnings: R8-10, R17-18– Reduced income of 2500 ECU vs. additional tax of 500 ECU (compulsory)
• Questionnaire:– Items: perceived fairness of tax authorities, voluntary compliance, subjective audit
probability, perceived severity of fine, perceived fairness of timing of feedback, general tax morale, socio-demographic data, etc.
Results I – Feedback x Compulsory Tax
Audit Reduced Earnings Mean immediate feedback = 50.75%, Mean delated feedback = 69.29%F (1, 122) = 11.30, p < .01
Covariate Gender:Mean females = 69.49%Mean males = 50.60%F(1, 121) = 7.44, p < .01
In experiments, uncertainty if tax report is audited is resolved immediately, whereas in real life it can take up to 7 years to know if your audited or not (Zeigarnik-Effect; unfinished businesses)
5 minutes 3 weeks
Compliance decision (pay 0-6 € tax)
Control group Experimental group
Compliance Rates: 28% 59%
Muehlbacher, Mittone, Kastlunger, & Kirchler, 2012
Immediate vs delayed audits
There is more than audits and fines, …
situational and personal characteristics; social norms, fairness, …
and perhaps the perception of taxpayers as cheaters is short-sighted.
Diffusion of income tax evasionPorcano (1988), the U.S. IRS estimated 10-15% of underreported income in 1983. Five years later the tax gap was about 17% of true liability.
Andreoni and colleagues (1998) estimate that over 25% of all U.S. taxpayers underpaid their taxes in 1988. In developed countries, tax evasion is estimated to reach 20% of the level of tax revenues, while in developing countries the percentages are even higher (Orviska & Hudson, 2002).
Slemrod et al. (2001) explain that the detected rate of non-compliance is 7.3%, but varies widely across types of gross income and deductions. In 1988, voluntary reporting was 99.5% for wages and salaries, but only 41.4% for self-employed income. In 2002, King & Sheffrin report that according to the U.S. IRS, 99% of wage income is correctly reported, but less than 70% of income from unincorporated businesses is correctly reported.
There is little doubt that non-compliance should be contained and evasion, in particular, needs to be combated. It is, however, wrong to assume that the majority of people try to evade or avoid paying taxes.
Long and Swingen (1991) write that some taxpayers are not predisposed to evade and do not search for ways to cheat. Survey studies and experiments on income tax behaviour show that honesty characterises a majority of participants (e.g., V. Braithwaite, 2003d; James & Alley, 2002; Kirchler, Muehlbacher, Hoelzl, & Webley, 2005).
Antonides and Robben found that 4.2% of participants in their study corrected their tax files to their disadvantage, whereas 23.8% corrected them to their advantage (Antonides & Robben, 1995). Assuming that those negatively correcting their files made unintentional mistakes, and an equal percentage of those who positively corrected their files did so also undeliberately, then less than 20% were intending to cheat.
On the basis of 1982 U.S. IRS audit data, Alexander and Feinstein (1987) report that approximately one quarter of all taxpayers make accurate tax reports. According to their analysis, 13.5% overstate their taxes, presumably due to errors in completing tax returns. If the same percentage understates their taxes due to errors, then more than half of taxpayers tend to be honest.
Hessing, Elffers, and Weigel (1988) estimate that more than two thirds of taxpayers declare their income honestly.
The assumption that taxpayers are generally compliant is challenged by the wide use of tax preparers and studies contending that taxpayers generally demand aggressive advice (Duncan, LaRue, & Reckers, 1989; Jackson, Milliron, & Toy, 1988; Milliron, 1988). These studies were conducted from tax preparers’ view, but investigations from taxpayers’ perspectives reveal a different picture. The use of a tax practitioner does not seem primarily driven by the desire to avoid paying taxes, but by the uncertainty about the tax law and the motivation to report correctly.
10-15% of underreported income
25% underpaid
7.3% non-compliance, wide variation across types of income and deductions
voluntary reporting 99.5% for wages and salaries, but only 41.4% for self-employed
4.2% corrected their tax files to their disadvantage, 23.8% corrected them to their advantage. Assuming that those negatively correcting their files made unintentional mistakes, and an equal percentage of those who positively corrected their files did so also undeliberately, then less than 20% intend to cheat.
¼ make accurate reports. 13.5% overstate their taxes, presumably due to errors. If the same percentage understates their taxes due to errors, then more than half of taxpayers tend to be honest.
2/3 declare their income honestly
The use of a tax practitioner does not seem primarily driven by the desire to avoid paying taxes, but by the uncertainty about the tax law and the motivation to report correctly.
Elffers (2000) writes, “[…] the gloomy picture of massive tax evasion is a phantom”.
Economic Psychology Agenda1. Self-Conception Ideas of Mankind
2. Objectivity & Intentions Methods
3. (Psycho-) Logics Economic Decisions
4. Rituals of Adults Lay Economic Theories
5. The Invisible Hand Markets
6. Mental Accounting Consumption, Saving, Loans
7. Trick & Treat Marketing Policy
8. Courage & Risk Businessmen/women
9. 20 US Cents Work & Satisfaction
10. Invulnerability Financial Markets
11. Whatever you want! Currency & Inflation
12. In the Shadow Counter-Productivity
13. Nudges State: Power and Trust
14. 75.000 US$ Prosperity and Happiness 31
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Cognitive scrooges:
Reality is subjectively construed and interpreted• Estimation of the diameter of coins• Optical illusions
Decision Anomalies: Perception of information
Paying back loans
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You have lended 3.000 € and need to pay it back with 12% annual interest rate. Each month you pay 30 €. How long does it take to pay the credit back?
(a) less than 5 years(b) 5 to 10 years(c) 11 to 15 years(d) 16 to 20 years(e) for ever
15%31%18%10%26%
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Emotions Probabilities are ignored or low probabilities are overestimated
The willingness to pay to avoid electric shocks barely depends on the probability of being exposed to electric shocks (Rottenstreich & Hsee: Money, Kisses, and Electric Shock: On the Affective Psychology Risk. Psychological Science, 2001)
1 % 99 %Probability
Shock
Money
0
2
4
6
8
10
12
14
16
18
Prices paid to avoid electric shock and $20 penalty
Risk and emotions
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Risk-aversion
Daniel Bernoulli (18th century): Human beings are
risk averse!
A sure gain of € 8.000 is
preferred to a possible gain (p = .85) of € 10.000.
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Risk-aversion and -inclination
a) Sure win of € 240 or25 % chance of winning € 1.000 and 75 % chance of winning 0
b) Sure loss of € 750 or75 % chance of loosing € 1.000 &25 % chance of loosing 0
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Prospect Theory
Descriptive decision theory explaining a number of decision anomalies in decision making under risk.
Phase 1: EditingSimplification of the decision problem
Phase 2: Evaluation Assessment of the alternatives
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Prospect Theory
Phase 1: EditingSimplification of the decision problem
Coding: What is an event related to (reference point)?
Combination: Independent events are often seen combined.
Segregation: Safe events are often separated from risky ones.
Cancellation: Identical aspects of two alternatives are ignored whereas disparities are weighted heavily in judgments.
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Prospect Theory
Phase 1: EditingSimplification of the decision problem
Simplification: e.g. odd numbers are rounded. In the case of very low or very high probabilities this process is fundamental.
Detection of dominance: Salient alternatives are discarded in the beginning and are not taken into account any further.
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Phase 2: EvaluationAssessment of alternatives
Assessment is guided by two principles
• The value is estimated in relation to a reference point.
• Probabilities are taken into account.
Prospect Theory
Subjective value +
-
A B
-A -B
convex
concave
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Prospect-Theorie
Reference
pointLoss Gain
42 42420
0
0.5
1
0.5 1Probability p
De
cisi
on
wei
gh
t
Prospect Theory: Weighting function
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Neuropsychology / NeuroeconomicsSupport for the assumptions of the prospect theory comes from neuroeconomics, examining the brain activity while decisions are made.Neuroscientific methods allow the analysis of the activities of the human brain (e.g. Prince & Pawelzik, 2008). In addition to imaging and psychophysiological methods, the measurement of individual neurons, the electrical brain stimulation or the elimination of brain regions can be counted among the methodological tools of neuroscience and, more recently, of neuroeconomics. First and foremost imaging and psychophysiological methods are used. Apart from the electroencephalogram (EEG), positron emission tomography (PET) is used, which allows the creation of cross-sectional images of the brains of humans and mapping biochemical and physiological processes. Currently, functional magnetic resonance imaging (fMRI) is most popular. This method allows the representation of metabolic activity in the brain by measuring the magnetic properties of oxygenated and deoxygenated blood. Using psychophysiological methods, different physiological responses to a stimulus, such as blood pressure, heart rate, sweating, dilated pupils or muscle tone, can be measured (Sanfey, 2007). Many studies have shown that economic decisions are correlated with neurophysiological processes (e.g., Delgado, Locke, Stenger, & Fiez, 2003; Knutson, Taylor, Kaufman, Peterson, & Glover, 2005). Sanfey, Rilling, Aronson, Nystrom, and Cohen (2003) examined fMRI responses of the players to fair and unfair offers in the ultimatum game and found out that in the case of rejected, unfair offers other brain regions are activated, as in the case of accepted, unfair offers.
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5 251. Choose 5 or 25
3. Result: 25 gain & correct 5 gain & incorrect
25 loss & incorrect 5 loss & correct
2. Outcome: gain or loss
4. Brain activity:265 milliseconds after the information about a win or loss => higher amplitude of a potential springing from the frontal area of the Cerebrum Medium in the event of a loss.
Experiment
Libertarian Paternalism
• Asymmetric (libertarian) paternalism:– Does not affect rational decision makers;– Works to the advantage of biased decision makers.
• Policy applications– Providing information;– Framing;– Changing status quo;– Format effects;– Motivational effects.
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100
95
90
85
80
75
70
65
Compliance rate in percent
<-1.000 <- 500 <- 100 <- 0 >- 0 >- 100 >- 500 >-1.000
refund balance due
Size of refund or balance due (US $)
business income
wages/salaries
Tax compliance of people who are liable to wage tax and of self-employed persons as a function of the refund amount or balance due (Cox & Plumley, 1988; as cited in Webley et al., 1991)