Tax and Tax evasion

Introduction:

“The Centre for Policy Studies has labelled the treasury's new 50% tax rate as ‘unfair, complex, inefficient and damaging'”(telegraph.co.uk, 2009).

“Britart pioneer Tracey Emin is preparing to pack up her unmade bed and move to France because of Gordon Brown's 50 per cent tax for the rich” (bbc.com, 5th Oct, 2009).

News such as this reflect the common sentiment in the UK regarding UK government's plans to increase tax for the rich. This also breaks labor government's pledge not to increase taxes during its tenure. It is widely believed that unnecessary high taxes increases the possibility of tax avoidance and tax evasive behaviour among individuals and hence critics question whether there is any gain from increasing taxes.

This essay examines the tax evasion issue in western countries including the economic and personal reasons for tax evasion. This essay also discusses the possible ways of combating tax evasion; including personal and disciplinary approaches.

Tax and Tax evasion:

Tax could be defined as “a compulsory contribution to the government, imposed in the common interest of all, for the purpose of defraying the expenses incurred in carrying out the public functions, or imposed for the purpose of regulation, without reference to the special benefits conferred on the one making the payment” (Crowe, 1944). Crowe further states that it is just when it is imposed by a legitimate legislative authority, for a just cause, and where there is just distribution of tax burden.

The most interesting aspect of taxation is tax discrimination among people. Those who do not earn pay no tax and those who earn more pay more tax. In most cases the percentage of earning going towards taxes increases with the earnings. Interestingly, such tax discrimination exists only for income tax and other person based taxes but other generalized taxes such as sales tax are same for the rich and the poor. Interestingly, rich people require little assistance from the state and benefit little from paying taxes and yet they pay higher taxes. So taxes are government's instruments to redistribute part of the wealth in the society in order to make life affordable for all. The term ‘affordability' may explain the tax discrimination imposed by the state as government's feel that rich people can afford to contribute more to the state economy without serious effects on their own personal wealth. Poor people, on the other hand, have little to contribute and if the state asks them to pay more, state itself will have to revert back with support for same.

Tax evasion is a very common problem all around the world. There are two types of evaders: complete evaders or partial evaders. Complete evaders do not pay taxes at all while partial evaders pay taxes but hide a significant proportion of their tax liabilities. Complete evaders generally include people in the low income segment who can successfully evade taxes without being noticed. Partial evaders, on the other hand, are individuals with significant tax liabilities who can not hide all their earnings without being noticed. Partial tax evaders make use of the loopholes in the taxation system and seek expert advice on how to minimize their tax liabilities (Scotchmer, 1989).

There is difference between tax avoidance and tax evasion. Tax avoidance occurs when an individuals take advantage of loopholes within the system to save tax; for example setting up companies in tax havens such as Cayman islands. This is done legally and is often used by high end tax payers only. Tax evasion, on the other hand, is a criminal activity in which a person deliberately hides his income details in order to pay low tax. In recent months, there have been calls to tap both but governments seem mainly concerned with tax evasion.

Reasons behind tax evasion:

People have different perceptions of taxes and these perceptions are often negative. Due to the general negative perception, people tend to evade taxes. There are several reasons attributed to contribute to tax evasion. These can be broadly classified as:

(1) Perception of taxes.

(2) Enforcement related.

(3) Personal circumstances.

(4) Source of income.

Negative perception of taxes as most people find a higher tax unjustified, is the largest contributor to tax evasive behaviour of individuals and businesses (Clottfelter, 1983- cited in McGee, 1999). People also tend to balance taxes imposed against facilities/services (e.g. healthcare) provided by the governments. When people see that the facilities provided to them have not improved in accordance with the tax hikes, they tend to evade taxes (Rowley, Tollison & Tullock, 1988).

In the enforcement related factors are the factors relating to enforcement of taxing system. Research suggests that in countries with poor enforcement laws and corrupt officials, tax evasion issue is quite severe as compared to countries where tax enforcement laws are strict (Andreoni et. al., 1998). Thus people tend to evade taxes, if they can. Lack of enforcement promotes the belief that people can evade taxes and get away with it (Scholz and Pinney, 1993).

Personal circumstances are also a significant contributor to tax evasion. While people's financial circumstances change limiting their capacity to pay at times, their tax liability may remain the same if such limitations are not covered by tax benefit schemes (Morales, 1998). The reduction in surplus income can lead to tax evasive behaviour among individuals who find it ethical to pay only according to what is surplus income (Christian, 1994).

Also some people believe that many people cheat on taxes. This belief is so dominant among individuals that many do not consider this immoral anymore (Erard and Feinsteain, 1994- cited in McGee, 1999). The ethical aspect is quickly fading as evaders do not believe that they are stealing from the government; they rather believe that this is their hard earned money which the government is trying to claim and they are merely protecting it (McGee,1999).

Sources of income are also a large contributor to tax evasive behaviour among individuals. Individuals who have earned money through illegal means or by working illegally can not report their taxes. For example, a drug dealer or a person who is earning and claiming unemployment benefits at the same time will not report their earnings as this will directly threaten their source of income and will lead to criminal prosecution.

Researchers have used several methods to assess the scale of tax evasion including tax audit surveys, money demand methods, latent variable techniques, tax overhang methods, labour force surveys and surveys asking individuals how much they evade. According to some estimates, tax gap in the US in 2006 was around $345 billion which is equivalent to 14% of the federal revenues. UK being a similar society and similar fiscal system, figures will not be much different.

Self assessment and tax evasion:

Self assessment system for determining taxes is relatively new to the UK but in Australia it is more than two decades old. Individuals prefer freedom and tend to show positive sentiments towards the system that allows them the freedom and shows its trust. For e.g. Slemrod and Yitzhaki (2000) found that most of the self employed individuals reported their true income under self assessment system.

Various religious clerics (Cohn, 1998; Tamari, 1998) have advocated paying taxes stating that every individual have a responsibility towards the community it lives within. Most religions have justified paying taxes and religion abiding individuals generally do not go against the law. This confirms the belief that most individuals who will not evade taxes under audit system will not evade taxes under self assessment system. The behaviour of individuals under self assessment system is generally more positive then under supervised systems (McGee, 2005).

Steps to deter tax evasion:

To understand how tax evasion can be avoided, it is important to understand why people evade taxes. Adam Smith (1976) proposed four pillars of an effective taxation system; equality, certainty, convenience of payment and economics of collection. The could be explained by the following attributes of a justified taxation system:

Most common argument is that people evade taxes because they can. It should be thus first priority of the government to put strict measures in place which proposes strict penalties for evading taxes. It is a risk Vs return approach which requires that government increase the amount of risk in the equation to make returns less attractive. Punishments should not only include financial punishments because this will promote pay Vs punishment attitude in people where people will start weighing money against money. Punishments should include prison sentences for individuals who cannot justify the reasons behind tax evasion. However; government must adopt a flexible approach to accommodate any genuine personal circumstances.

Atkinson and Stiglitz (1976) discussed taxation in context of public financing including different issues such as desirability of housing subsidies, public utility pricing, congestion tolls, optimal indirect taxation, choice between credits and deductions and tax expenditures. People who find public financing by the government inadequate are likely to evade taxes. There should be transparent communication between the government and the taxpayer as to how the government spends taxpayers' money.

Some researchers have argued that removal of human interface from the taxation system may help resolve the problem. Accountants and other tax middleman, sometimes guide the potential taxpayers to evade taxes and removing them from the system will help. By allowing direct and proper guidance to taxpayers, government can reduce the number of middleman and hence the tax evading attitude.

Privatization of taxation system was proposed by Hood (1986) who suggested that privatization will overcome limitations of government tax administration in controlling tax evasion. Stella (1992) proposed ‘Tax Farming' as a method to curb tax evasion. Under tax forming, government leases out the collection system to a private entity who collects the revenue on government's behalf and shoulders the risk of attempts at tax evasion by the tax payers. Privatization of systems have been known to increase efficiency and reduce losses but this may also lead to unjustifiable mechanism, often adopted by private firms for extracting money from firms/individuals.

References:

Andreoni, James, Brian Erard and Jonathan Feinstein (1998). “Tax Compliance”, Journal of Economic Literature, 36, pp. 818-860.

Atkinson, A. B. and J. E. Stiglitz (1976) “The Design of Tax Structure: Direct

versus Indirect Taxation”. Journal of Public Economics vol 6: pp 55–75.

Christian, C. W. (1994). Voluntary Compliance with the Individual Income Tax: Results from the TCMP Study, in The IRS Research Bulletin, 1993/1994, Publication 1500 (Rev. 9-94). Washington, D.C.: Internal Revenue Service.

Cohn, G. (1998), The Jewish View on Paying Taxes, Journal of Accounting, Ethics & Public Policy 1(2): 109-120, reprinted in Robert W. McGee,

Elfers, Henck, Russel H. Weigel, and Dick J. Hessing (1987). “The Consequences of Different Strategies for Measuring Tax Evasion Behavior”, Journal of Economic Psychology, 8, pp. 311-337.

Hood, C. (1986), Privatizing UK tax Law Enforcement?, Public Administration, Vol. 64, Autumn, p. 319-33.

McGee, R.W. (1999). Why People Evade Taxes in Armenia: A Look at an Ethical Issue Based on a Summary of Interviews, Journal of Accounting, Ethics & Public Policy 2(2): 408-416.

McGee, R.W. (2005), Three views on the ethics of tax evasion, Andreas school of business working paper series available at http://www.sciencedirect.com

Morales, A. (1998), Income Tax Compliance and Alternative Views of Ethics and Human Nature, Journal of Accounting, Ethics & Public Policy 1(3): 380-399.

Nylén, U. (1998), “Ethical Views on Tax Evasion among Swedish CEOs,” Journal of Accounting, Ethics & Public Policy 1(3): 435-459,

Rev. Martin T. Crowe (1944), The moral obligation of paying just taxes, The Catholic University of America Studies in Sacred Theology No. 84.

Rowley, C.K., R. D. Tollison and G. Tullock (1988), The Political Economy of Rent-Seeking. Boston, Dordrecht and Lancaster: Kluwer Academic Publishers.

Scholz, John T. and Neil Pinney (1993). Do Intelligent Citizens Free Ride? The Duty Heuristic, Low-Information Rationality, and Cheating on Taxes., Department of Political Science, State University of New York, Stony Brook.

Slemrod, Joel and Shlomo Yitzhaki (2000). Tax Avoidance, Evasion, and Administration. NBER Working Paper 7473.

Scotchmer, Suzanne (1989). Who Profits from Taxpayer Confusion?, Economics Letters, 29, pp. 49-55.

Smith, A. (1976), An enquiry into the nature and causes of the wealth of nations, Vol. 2, Oxford: Clarendon press, pp 825-27.

Stella, P. (1992) Tax Farming - A radical Solution for Developing Country Tax Problem, IMF Working Paper No. 92/70.

Tamari, M.(1998), “Ethical Issues in Tax Evasion: A Jewish Perspective,” Journal of Accounting, Ethics & Public Policy 1(2): 121-132,

U.S. General Accounting Office (1990). Tax Administration: Profiles of Major Components of the Tax Gap. GAO/GGD-90-53BR.Washington, D.C.

Yitzhaki, S. (1987), On the excess burden of tax evasion, Public Finance Quarterly 15, 123-137.

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