• Rewarding Taxpayers
    Practices of Increasing Tax Compliance

    By Ksenija Cipek


    Authors: Ksenija Cipek and Iva Uljanić Škreblin - Ministry of Finance, Tax Administration


    Sun and Wind once had a fierce argument over who would be the more powerful. As they were arguing, they saw a man walking on a secluded road wearing a hat and a coat. It so happened that they agreed to demonstrate their powers to each other by convincing the said man to take off his hat and coat. Immediately the Wind started blowing toward the man. However, once the man realized that the Wind was blowing, he pressed his hat a bit stronger to his head and tightened his coat. So the Wind blew a bit harder. But the harder the Wind blew, the more the man pressed his hat to his head and tightened his grip on the coat. Finally, the Wind had no choice but to concede that he could not convince the man to take off his hat and coat. Then, when the Sun took its turn she smiled to the man and sent her warm rays to him. As the Sun was shining and the man felt the warm rays of the Sun he decided trying to do without his hat. The Sun continued to smile and shine and the man, being happy with wearing no hat, finally decided to take off his coat as well.

    The problem of tax evasion is usually approached in a ‘Wind’ fashion, that is, tax evasion is fought with negative sanctions such as fines or even imprisonment for non-honest taxpayers (e.g. see Allingham and Sandmo 1972). However, success of these measures has been rather limited (e.g. see Schneider and Enste 2000; Frey and Jegen 2001; Christie and Holzner 2006; Pickhardt and Sarda 2006). That is why more and more theories and research focus on positive rewards that will foster voluntary fulfillment of tax obligations and reduce tax evasion.

    Cécile Bazart and Michael Pickhardt: „Fighting Income Tax Evasion with Positive Rewards: Experimental Evidence“, February 2009.

    Greater understanding of the behavioral motive triggered by taxpayers in fulfilling or failing to meet their tax obligations can help the tax administration to adopt approaches that will increase voluntary compliance and which will improve the effectiveness of non-compliance activities.

    The first model, which in 1972 represented Allinghman and Sandmo, in its essence, was relying on the following theory: "Increasing the parameters of deterrence, eg. the probability of disclosure and the amount of punishment for unreported income, will always lead to an increase in actually reported income!" However, this theory was highly criticized, as it was considered not to be in line with empirical evidence of tax compliance. In the nineties, new discoveries have emerged with a new theory that other factors affect the behavior of taxpayers, for example: the application of informal punishments and positive strategies or actions that invoke conscience.

    Since 2000, numerous researches and analyzes have focused on seeking answers to the question: why people pay tax? As important aspects in explaining the level of tax compliance, the following elements were identified:

    • reciprocity,
    • the characteristics of tax exchange, legitimacy and respect between taxpayers and tax authorities,
    • moral or sense of civic duty.

    Tax exchange establishes a link between the taxpayer's contribution and the government's provision of public services. Nevertheless, although public service delivery can be considered a positive tax payer's award, it should be noted that due to the lack of transparency of spending or the inability to apply the principle of price exclusion, unfair taxpayers may benefit from providing public services in the same way as honest taxpayers. Therefore, it is worth analyzing the impact of positive rewards that are provided exclusively to honest taxpayers.

    Regarding the problem of tax evasion, positive rewards were experimentally tested by Alm, Jackson, McKee (1992), through various reward schemes. Honest taxpayers could either take part in the lottery or alternatively they could get a fixed lump sum. Their conclusion confirmed the effectiveness of positive incentives on tax compliance, and especially the experiment showed that lottery schemes have an advantage in ensuring fair reporting. Furthermore, Torgler (2003) has conducted an experimental test of the relative influence of various factors on the fulfillment of tax obligations (fiscal exchange, moral beliefs, etc., including positive rewards). The experiment was carried out in Costa Rica, and taxpayers from different professions participated. The experiment has shown that as many public services the government provide that match taxpayers' preferences in exchange for the appropriate tax price and the more they value honesty, than taxpayers are more willing to meet their tax obligations, and the highest tax compliance rate in this experiment has been achieved in the case of positive prize schemes.

    Furthermore, in 2007, Feld and Frey described the characteristics of the psychological tax treaty between taxpayers and tax administration and stressed the need for the common use of negative and positive incentives. The conclusion is based on the so-called "Crowding theory" which justifies the use of a well-designed combination of negative and positive incentives and implies the following:

    • activities that are perceived as intimidation (i.e. supervision or control) tend to exert intrinsic motivation for taxpayers to pay taxes,
    • the activities that are perceived as supportive tend to raise the intrinsic motivation of taxpayers to pay taxes,
    • if intrinsic motivation is not recognized, taxpayers feel that they can be opportunists,
    • it is expected that tax morals will not be reduced if honest taxpayers perceive that stricter policy is directed against unfair taxpayers.

    Furthermore, an experimental study conducted in France and Germany at the Faculty of Technology at Montpellier and Chemnitz Faculty of Technology on the analysis of the effects of positive rewards on the voluntary compliance of an individual showed that:

    • positive rewards in the form of individual pay-per-acquisition games (lottery games) for fair taxpayers have a strong positive impact on the fulfillment of tax liabilities by shifting potential taxpayers who would like to avoid paying taxes in the category of honest one,
    • this positive impact on tax compliance is particularly important for men, as they are more likely to avoid paying taxes than women,
    • the introduction of winnings on game of chance for fair taxpayers will be quite effective in the form of a rise in total tax revenue in economies with a low rate of voluntary tax compliance and a high share of male taxpayers.

    First year students of economics and business administration participated in the research and by random selection it was possible to realize a prize in the form of a percentage of total revenue if those taxpayers showed their total income at the end of each circle in the experiment.

    Other research has also shown that the combination of positive awards and penalties positively affects voluntary tax compliance. However, when it comes to determining the award itself, very important factors that need to be considered are:

    • type of awards - there are different options that tax administration can use when it comes to the type of prize itself, which may be direct cash payments (either as a percentage of earned income or a fixed amount equal to all), prize games or prizes in the form of gifts, services, etc. (for example, better and cheaper access to public services, free public transport, free access to cultural activities, free and privileged access to public museums, free entrance to sports and recreational facilities, etc.) The prize structure or prize type may also have an impact to the effect of these positive incentives. For example, Alm, Jackson and McKee (1992) carried out a laboratory study of the impact of a particular type of reward on the fulfillment of tax obligations. The research showed that the lottery had the greatest effect on the fulfillment of tax obligations, and behind it were a fixed prize and awards in the form of a reduction of tax audit, although the prize that could be won on the game of chance and the fixed prize were approximately the same. This finding was backed up in 2004 by neuroscience research that has shown that the reward in which subjects get acquainted with the outcomes brings moderate dopamine excretion (which is responsible for reactive behavior) and an unpredictable cash prize produces significant dopamine excretion1. Feld and Torgler in their article2 state that the reward in the form of the same amount of money as the paid tax will not positively affect the tax compliance because it can be perceived as a reclamation or a refund rather than a reward and in that sense the non-cash prize would be a more positive solution, because it would be perceived as a sign of recognition;
    • the income effect - in general, the income effect on tax compliance is difficult to estimate, because it depends, for example, on tax preference and tax rate progressiveness. However, if the award is very small in relation to the tax obligation, the likely revenue effects will most likely be very small;
    • the discovery of a "good" taxpayer - a very important element is how to define and determine who is the "good" taxpayer who should receive the award, otherwise, for example, someone who is shown to have avoided paying taxes will not only reduce the effect of reward but also undermine the reputation of the tax administration. The challenge in this respect is a good assessment of every tax payer, which in practice is often not easy to achieve. However, certain criteria may be set out which will be known to everyone in advance for the whole process to be transparent as much as possible, for example: submitting a tax form within the deadline, paying tax within the deadline, reporting total income, no irregularities in the tax audit procedure etc. If the tax administration does not use well-designed, automated tools for tracking each taxpayer according to the set elements, this will increase the cost of the entire remuneration process;
    • Reward Size and Tax Cost Effectiveness - According to standard economic theory, it is expected that the reward will change the relative price in such a way that tax payments will be more attractive than avoiding the payment of taxes. However, in order for the award to be cost effective, it must increase net tax revenue, i.e. gross tax revenues minus the cost of rewards must be higher than before rewarding;
    • Strategic Behavior - Another element that needs to be taken into account when introducing reward for good taxpayers is the strategic behavior of taxpayers. Namely, if, for example, awards are given for behavioral changes (for example, from bad to good taxpayers), it can encourage taxpayers to first behave like bad taxpayers, or increase tax evasion, to reduce it in the second step to generate larger reward. Therefore, it should be borne in mind that the reward is given to taxpayers who are really and fully honest. However, with taxpayers who neither seek ways to cheat on taxes, the reward will not have a significant impact. It can therefore be concluded that the relative price change, as a result of a higher sentence or higher reward, will have an impact only on taxpayers with a relatively low tax morale that are prone to cheating;
    • Time Effects - it is also very important that the reward must be timely and relevant to produce quantizable significant effects. Research has shown that there is a tendency for the reward effect on tax compliance to decline over time. It is also expected that those taxpayers who have been rewarded once and can no longer be rewarded, will have no incentive any more to increase or maintain their good behavior unless the rewarding have the condition that the taxpayer will have to reimburse the prize if he fail to meet his tax liabilities in a certain time period;
    • Citizens vs. Businesses - Tax incentives must be specifically targeted at particular taxpayer groups, as these groups may react differently to the same incentives. As a rule, different awards for individuals and companies should be devised, as it would be very difficult for companies to find adequate remuneration measures for individuals within the company. One of the positive examples of company rewarding is the issuance of certificates to those taxpayers who properly and timely fulfill their tax obligations and cooperate well with the tax administration. Such a certificate would be a sign that it is a good taxpayer and could increase the reputation of that enterprise, which brings along a number of other indirect benefits, such as an increase in stock market value, increased credit rating, better market conditions, increased consumer trust in the product quality of the company etc.

    In addition to rewarding taxpayers as an incentive for their "good" behavior in meeting their tax obligations, the reward can also be given to third parties that will, by their behavior, increase the taxpayer's compliance. One example is the lottery game conducted in Croatia in the context of fiscalization, for citizens who had to collect invoices that have passed the verification by the TA and that have been registered in the TA before issuance by the seller; and send them to the Tax Administration if they wanted to take part in the lottery game. The purpose was to increase the number of cash invoices that had undergone a fiscal procedure, or that were properly registered with the Tax Administration, by the help of citizens who had to ask and take the invoice with them after buying products or goods and paid in cash. During the first round of the third season of the lottery game (in 2015) Croatian citizens have sent more than 80,000 envelopes with more than 1,600,000 invoices. That was nearly twice as many than in the first two seasons, which was a clear sign that citizens continue to largely support fiscalization, the introduction of order and the suppression of the gray economy.

    Portugal is also one of the countries that introduced a prize game for properly reported and issued invoices, but in the way that the buyer had to give his tax number to be entered into the system (i.e. to be inserted as an invoice's element) and delivered in real-time to the tax administration along with other invoice elements. Doing that the buyer automatically became a participant in the tax administration prize game where he could win a new, luxury car (about 60 cars a year). After that, the system is adjusted to the extent that taxpayers-natural persons for purchasing goods or services in certain branches of the economy that are considered the most risky in terms of tax evasion in particular of VAT (beauty salons, hairdressing salons, car services, accommodation, catering, etc.), can get tax relief in the form of returns of income tax paid based on invoices reported on which their tax number is stated, i.e. on the basis of VAT paid.

    In Chile, for example, when VAT was introduced for the first time (in the eighties), taxpayers - buyers, who sent 30 accounts with VAT, could won a fully furnished apartment. And other Latin American countries (Brazil, Argentina, Costa Rica) had prizes for taxpayers. In China, the arrival of capitalism brought fapiaos, scratch-and-win invoices (1998), special invoices with a hidden number thanks to which the buyer could won up to a maximum of € 6,000.00, which proved to be very popular and the survey in 2009 showed that there was an increase in tax revenue by 10.4%. In Taiwan, a prize game was launched in 2013, where customers automatically received an invoice containing a certain number, and every two months there was a television draw of winning numbers, but the winners did not get the money, instead the money was donated for charitable purposes. Greece and Slovakia have introduced lottery in 2013 to encourage citizens to ask for purchase invoices3. In Slovakia, every invoice worth more than 1 euro could participate in the lottery, and a car could be won, a cash amount of EUR 10,000.00 or participation in a special game. About 450,000 people participated in the game, registering about 60 million invoices4.

    The goal of all these rewards for citizens is clear: to encourage the sellers of goods and service providers to report to the tax administration all their revenues.

    1. Zald, D.H., I.Boileau, W. El-Dearedy, R. Gunn, F. McGlone, G.S. Dichter and A. Dagner (2004): ¨Dopamine Transmissions in the Human Striatum during Monetary Reward Tasks¨, Journal of Neuroscience. 24: 4105-4112.
    2. Lars P. Feld and Benno Torgler (2006): ¨Rewarding Honest Taxpayers? Evidence of the Impact of Rewards from Field Experiments¨, https://www.researchgate.net/publication/4846795
    3. https://elpais.com/elpais/2014/03/04/inenglish/1393945704_491405.html
    4. https://www.nytimes.com/2014/04/20/world/europe/forget-the-car-in-slovakian-lottery-real-prize-goes-to-tax-man.html
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  • The information provided in this article is for general information purposes only. The information is not intended to be comprehensive or to include advice on which you may rely. You should always consult a suitably qualified professional on any specific matter.

Ksenija Cipek

Ksenija Cipek is based in Zagreb, Croatia and she is a lecturer at the local University of Law and a Member of European Law Institute. Ksenija has over 20 years experience working at the Ministry of Finance and the Tax Administration. She is a highly respected and recognised tax expert who has been heavily involved in lawmaking. Ksenija is also an author and books writer.

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