Tax Compliance Under Tax Regime Changes

Changes to the degree of a tax system’s progressiveness are a key element of many introduced or considered tax reforms. Especially, flat tax reforms have received increasing attention resulting from their popularity among Eastern European countries. Proponents claim that their simplicity and incentives raise compliance. However, natural experiments do not allow for an unambiguous identification of the driving forces behind tax compliance, because it is very difficult to disentangle several competing explanations. Relevant variables such as the tax tariff, changes in the effectiveness of the tax administration, and the general social and economic environment change concurrently. In this paper, we analyze the effects of tax regime change in a laboratory experiment. More specifically, experimental subjects face one tax regime for a certain commonly known number of income statement decisions before they experience another regime. Our first and foremost focus in this study is on the impact of a reform on individual tax compliance from a progressive towards a proportionate tax tariff and vice versa. However, our experiment features two further interesting aspects: First, we let our participants choose between the two tax regimes that they encounter during the experiment after they have experienced both regimes. Second, an innovative feature regarding our experimental design is that the taxable income in the experiment depends on individual achievements before the introduction of the tax game. This feature induces stronger entitlements over the taxable income and increases the external validity of our experimental setup. Our empirical results corroborate the view that compliance is affected by regime changes beyond the predictions of the traditional economic model of tax evasion. As predicted by the traditional model, the proportionate system, due to its lower tax rate, is characterized by a lower share of income honestly declared. Since the penalty for tax evasion is proportionate to the amount of tax evaded, it is less risky not to declare income with a lower tax rate. Beyond this level effect, there is however an interesting impact of the direction of reform: A change from a progressive to a proportionate system is significantly more beneficial for a public authority in terms of tax compliance than a switch in the reverse direction. This result hints to the importance of the pre-reform point of reference in the individual compliance decision. Furthermore, reform losers tend to evade taxes to a greater extent after the reform compared to reform winners. Again, theories including reference points or aspiration levels are able to organize our data well. The preference for one of the two systems on the individual level is strongly influenced by monetary considerations.

Heinemann, Friedrich and Martin Kocher (2010), Tax Compliance Under Tax Regime Changes, ZEW Discussion Paper No. 10-020, Mannheim.