Tax Compliance

Abstract

A psychological tax treatment goes beyond the traditional deterrence model and explains tax morale as a complicated interaction between taxpayers and the government. As a contractual relationship implies duties and rights for each contract party, tax compliance is increased by sticking to the fiscal exchange paradigm between the citizens and the state. Citizens are willing to honestly declare income even if they do not receive a full public good equivalent to tax payments as long as the political process is perceived to be fair and legitimate. Moreover, friendly treatment of taxpayers by the tax office in auditing processes increases tax compliance. In Bangladesh this kind of contractual relationship has not yet been established. Actually respectful treatment from the tax authority and incentives plays critical role in creating a psychological effect on the taxpayer mind. And it is the duty of the government to make proper utilize of the tax money. If the taxpayer realized that their earnings going out by the form of tax is properly used then the economic theory does not work in some places.
We perform a sample survey for the purpose of assessing the viewpoint of Bangladeshi taxpayer towards their experience and concepts about whole tax payments systems and the role of tax authority in response of problem solving. But it is a matter of regret that majority hold a negative aspects about these. This result actually matches to the current scenario of our taxation.
Actually respectful behavior from the tax authority and if meaningful contractual relationship be established then it is expected that the rate of noncompliance and tendency of tax avoidance and evasion will be reduced dramatically.

1. Introduction
The reason of tax compliance is a complex issue. It is often argued that citizens value the public goods financed by the money of other taxpayers, but that they themselves are reluctant to pay their own taxes. This reluctance to pay taxes is often explained by various theories, or “research paradigms”: by theories that emphasize individual self-interest, by alternative theories of individual motivation, by perspectives that focus on group interactions, by doubts concerning the responsible spending of the taxes by the government and its tax authorities, and the like. A strong tradition here is the economics-of-crime paradigm that views the decision to pay taxes as an individual’s choice between a sure option of paying all taxes honestly and a risky option of evading taxes. Depending on the audit and fine rates, the risky option may result in a higher or a lower payoff compared to the sure option. In this paradigm, tax compliance is understood mainly as the result of a rational “portfolio” decision by a single taxpayer. However, this research paradigm has been increasingly challenged as incomplete, both by economists but especially by psychologists, and especially under the premise that the complex decision to pay taxes cannot be understood solely by framing this decision as a decision under risk made by a single taxpayer. There are more “actors in the field” whose separate behaviors, whose different motivations, and whose dynamic interactions must all be considered as a way of explaining compliance. The consideration of these actors, their behaviors, and their interactions has given rise to other and emerging research paradigms for the analysis of tax compliance.
In this paper we discuss a more recent research paradigm which is tax compliance as the result of a psychological tax contract. A psychological tax contract goes beyond the traditional deterrence model and explains tax morale as a complicated interaction between taxpayers and the government. It emphasizes that tax compliance behavior can be broadly viewed as a “psychological contract” between taxpayers, the tax authorities, and the government. Central to this contract is the broad notion of a “social norm” of behavior.

1. Methodology and Limitation
According to direction, we are assigned a article titled “Tax compliance as the Result of a Psychological Tax Contract: The Role of Incentives and Responsive Regulation” by LARS P. FELD and BRUNO S. FREY. Our majority efforts have gone by analyzing and explaining the article. In addition we formulate a questionnaire to get some insight about the psychological tax treatment in Bangladesh perspective. It is important to mention here tax is subject that is far from easily understanding and explaining. As a fresh graduate we have used our full expertise and analytical ability to explain the article. 2. Traditional model of taxation
The central insight of the model is that nobody likes paying taxes, not least because it involves a public good and there are incentives to free ride. In order to prevent individuals from free riding on public goods, coercive taxation has to be used. The tax code is enforced by a system of fines and audits. Individuals decide by maximizing expected utility such that a risk-averse individual, who earns a certain amount of money, chooses the share of income he/she wants to declare to the tax authority. The incentives for rational and selfish individuals to voluntarily pay taxes are pretty low because undeclared income is not taxed. Therefore the individual needs to face a certain threat of punishment if he/she does not truthfully declare his/her income. He/she is audited with a certain probability of detection and fined by a penalty tax rate when tax evasion has been detected. 3. Economic theory of crime
The extent of deterrence, as the product of the probability of being detected and the size of the fine imposed, determines the amount of income evaded. However, in view of the low deterrence applied in most countries, because of a low intensity of control or small penalties, taxpayers should evade more than they actually do, that is, and compliance is too high.

4. Factors relating tax evasion
Tax evasion increases with the tax rate and decreases with the level of fines and with the audit probability (Friedland et al., 1978).Tax evasion are lower when the proceeds are used to provide a public good (Alm et al., 1992). Decision whether or not to evade is made jointly with the decision on how much effort to put in income earning activities (Collins & Plumlee, 1991). 5.1 Role of non-economic factors
• A large subset of people never cheats, because they appear to believe that cheating is wrong.
• Social norms are important
– operationalised as a perceived prevalence or acceptance of tax evasion among a reference group
– People’s social networks and associations help shape their perceptions, norms and attitudes, which then influence their responses to imagined and actual sanctions (Smith & Kinsey, 1987).
– Taxpayers perceptions about evasion and fairness have a direct influence on compliance.
−individuals, who perceive evasion as prevalent, and/or to be an insignificant crime, tend to be less compliant. 5.2 Institutional factors
• Direct democracy and individual voting on different aspects of the fiscal system decrease tax evasion
• Tax evasion decreases with a higher trust in governmental institutions, a higher perceived fairness of the tax administration and with a perceived equity of the fiscal exchange
• Federalism and decentralization appear to be beneficial to tax compliance

5. Theory of non-compliance
It says that the subject as an amoral profit-seeker whose actions are motivated wholly by rational calculation of costs and opportunities. This assumption underlies the deterrence theory approach - a taxpayer is likely to break the law unless anticipated legal penalties exceed the additional earnings that could be made by evading tax. 6.1 Limitation of this theory
• It does not satisfactorily explain the high levels of observed compliance
– USA: majority of taxpayers are compliant even when the possibility of detection and punishment for non-compliance is obviously slim.
– Australia: taxpayers report being generally compliant even when they believe others are not.
• Taxpayers attitudes towards the tax system, rather than (or in addition to) purely economic calculations (opportunities for cheating) or fear of punishment, are important in explaining taxpayers non-compliance. Attitudes are more important than opportunities in determining taxpayer’s behavior.

6. The psychological tax contract
According to this model, tax payment is taken to be a “quasi-voluntary” act and the tax authority must acknowledge that external interventions in the form of rewards or sanctions may crowd out that intrinsic motivation to pay taxes. The idea of intrinsic motivation is largely attached to psychology. A group of cognitive social psychologists have identified that, under particular conditions, monetary (external) rewards undermine intrinsic motivation. Giving of rewards for undertaking an activity has indirect negative con-sequences as rewards lead to the expectation of future rewards such that desired behavior is undertaken only if rewards are provided.

Frey (1997a) generalizes this basic idea in three ways: (a) All types of external interventions may negatively affect intrinsic motivation that is, not only offering rewards, but also by issuing commands and imposing rules and regulations as well as punishments. Thus, deterrence imposed by the tax authority may undermine individuals’ intrinsic willingness to conform to tax laws.
(b) The intrinsic motivation affected by external intervention is broadly conceived. It comprises actions undertaken for their own sake that is, without expectation of external reward, as well as internalized norm-guided behavior. The latter is the relevant concept as far as taxpaying is concerned.
(c) External interventions undermine intrinsic motivation when they are perceived to be intrusive by the individuals concerned (“crowding-out effect”), and they maintain or raise intrinsic motivation when they are perceived to be supportive. The underlying psychological processes depend on how self-determination and self-esteem are affected. Tax audits as intrusion by tax authorities can undermine tax morale more strongly if the taxpayers’ sense of self-determination is high.
Tax officials are assumed to be aware of the effects on taxpayers’ behavior suggested by crowding theory. They know that a disrespectful treatment of taxpayers undermines tax morale and therewith increases the cost of raising taxes. At the same time, tax authorities will only behave in respectful way towards taxpayers when there is a substantial amount of tax morale to begin with. Tax officials are well aware that tax payments do not solely depend on tax morale but that extrinsic incentives play a major role. In particular, incentives are used to prevent taxpayers with low tax morale from exploiting the more honest taxpayers escaping paying their due share. A combination of respectful treatment and incentives is possible and widely practiced. The sole reliance on incentives, as suggested by a large part of the tax compliance literature based on subjective expected utility maximization, represents a special case, which only applies under restrictive conditions. Such a special case occurs when the tax officials are convinced that individuals’ tax morale is low or does not exist at all. In general, however, it is optimal to use both respectful treatment as well as incentives simultaneously. Tax officials who recognize that the crowding-out effect will be stronger where there are initial high levels of tax morale, will put less weight on incentives, and will treat taxpayers more respectfully.
This relationship between taxpayers and tax authorities can be modeled as an implicit or relational contract, which involves strong emotional ties and loyalties. Social psychologists have been using this concept for a long time, calling it a “psychological” contract to set it apart clearly from formal contracts, which are obeyed because the parties respond to the explicit and material sanctions previously agreed upon, for example, use psychological contracts to successfully analyze the organization of firms. They could also be used in tax compliance analysis, suggesting that incentives and respectful treatment are important determinants of tax compliance.
In the psychological tax contract, punishment still plays a role in order to provide deterrence. But the satisfaction of taxpayers with what they get from the other contract party, that is, the government, mainly influences their tax morale. Taxpayers’ reward from that contract must be under-stood in a broad sense going beyond pure exchanges of goods and services for the payment of a tax price. In addition to such direct exchange components, the fairness of the procedures leading to particular political outcomes as well as the way the government and the taxpayers treat each other are part of the contractual relationship. A genuine reward is therefore obtained only if taxpayers as citizens have an inclusive, respectful relationship with the community. Both sides of the contract perceive each other as contract partners and treat each other with mutual respect. As deterrence and tax morale interact, it would be counterproductive solely to rely on punish mentor monetary (non-authentic) rewards, because tax morale can be undermined. A dynamic relationship results in which deterrence, monetary rewards, fiscal exchange, but also decision-making procedures and the treatment of taxpayers play a role.
The contractual metaphor has many advantages over traditional theoretical approaches. It underlines first, that paying taxes is a quasi-voluntary act. Each party has to agree to the contents of the contract. In practice, it is seldom the case that each public good is individually contracted with each taxpayer for a certain tax price. However, a steady reduction in tax compliance need not only be interpreted as a violation of the law, but also as taxpayers’ discontent with what they receive for their taxes. Second, the contractual approach emphasizes the role of fair procedures decided upon at a constitutional stage. It can be argued that people comply with the law in general if they perceive the process that leads to this law as fair. Most obviously, it will be difficult to think of a psychological tax contract in autocratic regimes. The inclusiveness of political decision making could, however, also be very different in democratic regimes, depending on the extent of citizens’ involvement in political decision making. This second advantage of the contractual metaphor stems from its potential to include notions of procedural fairness almost by construction. Third, the way people are treated by the tax authorities affects cooperation levels. Again the analogy to private contracts is useful. If one can purchase a product from two different suppliers, would he choose the one that is more friendly and respectful when treating customers? The answer would be yes, providing the price differential was not too high. In a similar fashion, the way the tax office treats taxpayers plays a role.
At this procedural level, respectful treatment can be split into two different components. First, the procedures used by auditors in their contact with taxpayers are to be transparent and clear. In the case of arbitrary procedures, taxpayers feel helpless and get the impression that they are “corks bobbing on an ocean” and not to be taken seriously. Such behavior reduces their perception of being obliged to pay taxes. Second, respectful treatment has a direct personal component in the sense of how the personality of taxpayers is respected by tax officials. If they treat taxpayers as partners in a psychological tax contract, instead of inferiors in a hierarchical relation-ship, taxpayers have incentives to pay taxes honestly. In addition, respectful treatment of taxpayers enforces the effects of emotions on compliance behavior.
Two opposite cases of treating taxpayers can be distinguished: (1) respectful treatment supporting, and possibly raising, tax morale; and (2) authoritarian treatment undermining tax morale. The tax officials can choose between these extremes in many different ways. For instance, when they detect an error in the tax declaration, they can suspect intent to cheat, and impose legal sanctions. Alternatively, the tax officials may give the taxpayers the benefit of the doubt, and inquire about the reason for the error. If the taxpayer in question indeed did not intend to cheat but simply made a mistake, he or she will most likely be offended by the disrespectful treatment of the tax authority. The feeling of being controlled in a negative way, and being suspected of tax cheating, tends to crowd out the intrinsic motivation to act as an honorable taxpayer and, as a consequence, tax morale will fall. In contrast, if the tax official makes an effort to locate the reason for the error by contacting the taxpayer in a courteous way, the taxpayer will appreciate this respectful treatment and tax morale will be upheld. 7. The impact of tax deterrence on Tax compliance
Psychologically tax deterrence has various aspects. The survey by Andreoni, Erard & Feinstein & by Slemrod & Yithzhaki predicts for a positive impact of deterrence on tax evasion. The higher the tax evasion the lower is the tax evasion-ceteris paribus.Spicer & Ludesteldt, Friedland, Elffers,Weiged & Hessing & Verma & Doob present ambiguous evidence. Feld & Frey supported for the type of ambiguousness. A panel of Swiss cantons found that the higher intensity of control increases tax evasion, while fines & penalties reduce tax evasion.
Higher control intensities increase deterrence & thus tax compliance on the one hand but may be perceived as intrusive by tax payers & thus reduce tax compliance. Feld & Frey have provided evidence that fines & penalties are part of a non-linear punishment schedule. This allows for low levels of fines in the case of minor offences against the tax code, even tax amnesty in the case of self denunciation, in order to reduce tax payers perception of intrusiveness but requires high penalties in case of tax fraud or major convictions in order to make clear that the psychological tax contract is at stake.
Deterrence has two aspects. On the one hand in order to keep us a psychological tax contract between the tax office & the taxpayer’s honest taxpayers must be confident that they are not exploited by tax cheaters. On the other hand each taxpayer may make mistakes that minor offences can be penalized less without undermining the psychological tax contract. A non linear punishment schedule with low fines for minor tax evasion & high penalties for tax fraud, will serve the purpose of shaping tax morale. All in all the evidence suggests that an exclusive reliance on deterrence is not a reasonable strategy to increase tax compliance. 8. Rewarding taxpayers * In contrast to the standard model of tax evasion, rewards raise the benefits of paying taxes. Here two conditions should be met. 1. The income effect induced by increasing the wealth position must not work in the opposite direction to the effects operating without the reward. 2. Reward may induce strategic behavior when offered to reduce evasive behavior. here strategic behavior is not rational option as it depends on being a good taxpayer. * Rewards are perceived as supporting & raising tax morale in contrast to deterrence. * Reward may take form of monetary Pmt proportion to the size of the tax pmt. That may be same size for all good taxpayers. * Tax is better to be given in non-monetary form as it is a sign of acknowledgement. It increases tax morale than money. * These forms may be free entry to museums, exhibitions etc. * All in all rewards lead to better outcomes than punishment

9. Tax compliance and social exchange
From the perspective of standard economic theory, a much more direct incentive for tax compliance than deterrence or rewards takes the form of the goods and services that the state provides to citizens for their tax payments (Mackscheidt 1987; Smith & Stalans 1991). If the analogy to provide contracts is considered, the goods or services purchased provide the foremost incentives to pay the price for these goods and services.
From the perspective of a psychological tax contract, respectful treatment is acted out at two levels, through the fiscal exchange and through procedures. The fiscal exchange between the state and its citizen requires that citizens’ tax payments are met by public services provided by the government. According to the benefit principle of taxation, Taxes are prices for certain public goods. However, the benefit principle does not necessarily imply that income redistribution becomes impossible, and only infrastructural goods as well as public consumption goods are provided by the state. Citizens may perceive their tax payments as contributions to the bonus commune such that they are willing to declare their income honestly, even if they do not receive a full public good equivalent to their tax payments. Income redistribution is more likely to be accepted by affluent citizens when the political process is perceived to be fair and the policy outcomes legitimate. 10. Establishing social exchange between citizens and the government
Empirically, the more governments follow the benefit principle of taxation and provide public services according to the preferences of taxpayers in exchange for a reasonable tax price, the more taxpayers indeed comply with the tax laws. It is found that the more the citizens’ optimal choice of a public good and the actual provision level and quality deviate from each other, the higher tax evasions is. Tax compliance also increases with reductions in government waste. In the experimental papers, the proposed fiscal exchange relationship is based on the provision of a public good financed by taxes. Several authors have used this analogy to public good financed by taxes. Several authors have used this analogy to public good games in order to analyze additional variables that influence tax evasion. According to the benefit principle of taxation, such a restricted view of government action could be rationalized.
However, in real- world settings the state undertakes many activities that cannot be subsumed under the heading of a public consumption good or public infrastructure. In particular, any kind of pure redistribution is not covered by such a design. Whenever, redistribution of income is at stake, problems of tax evasion are pertinent. However,(1989) report that evasion rises if taxpayers believe the loose from redistribution.
Kinsey and Grasmick (1993) reported that horizontal equity plays a role. If an individual’s tax burden is of about the same magnitude as that of comparable others, tax compliance increases. In particular, trust in government can be eroded if government waste is high, Ahmed and Braithwaite (2004) report empirical evidence on a significantly higher non-compliance among those that have lost hope, that is, who believe that trustworthiness of the government is low.

11. Establishing fiscal exchange by political decision making procedures
The fiscal exchange relationship between taxpayers and the state therefore depends on the politico-economic framework within which the government acts.
In an experimental study, Feld and Tyran (2002) found that tax compliance is higher on average in an endogenous fine treatment in which subjects are allowed to vote on a proposed fine, exogenous fine treatment where the fine is imposed by the experimenter. The main explanation why people show higher tax morale if they are allowed to vote on a fine is legitimacy. Subjects who approved the fine in the endogenous fine treatment have considerably higher tax compliance than subjects in the exogenous fine treatment. Also, compliance rates are higher if the fine is accepted than is rejected. Further-more, subjects who reject the proposal of the fine show a higher compliance rate than subjects who reject the proposal of the fine show a higher compliance rate than subjects in the exogenous fine treatment.
Field studies by Pommerehne and Wech-Hannemann (1996) have provided addition support for the experimental finding. Focusing on tax evasion in the Swiss cantons between 1965 and 1978, they found that the more direct democratic the political decision-making procedures of a canton are, the lower tax evasion is. Given that studies both in the U.S.(Gerber 19990 and Switzerland (Pommerehne 1978) have shown that policies in direct democratic jurisdictions are more strongly in line with citizens’ preferences, institutions of direct democracy can be seen as a means of establishing a relationship of fiscal exchange between taxpayers and the government.
In addition, Torgler (2005) has reported evidence that local autonomy as an indicator of fiscal federalism has a marginally significant positive impact on tax morale. Guth,Levati and Sausgruber (2005) found a stronger effect of fiscal decentralization on tax compliance in an experimental setting. Subjects showed higher tax morale if public goods were provided and financed regionally or locally because their taxes were spent on their own regional or local public goods. The fiscal equivalence of the theory of fiscal federalism then holds more strongly.

12. The treatment of taxpayers
Frey and Feld (2002) argued, the psychological tax contract presupposes that taxpayers and tax authority treat each other like partners with mutual respect and honesty. If tax authorities think themselves superior to taxpayers, the contractual relationship between them will be violated and taxpayers will likely to evade taxes. Feld and Frey made a survey in Switzerland in 2002 regarding the issues. They wanted to reveal the legal background of tax evasion along with questions on the treatment of taxpayers by tax authorities in day-to-day tax audits, in particular when a taxpayer is suspected of not declaring his or her true taxable income. They made the survey in 26 Swiss cantons. Cantons are small tax jurisdiction areas. It is noted here that Switzerland is the most tax favored country provided that the tax rate here is only 22% whereas it is 30% to 55% in other EU countries. Rather tax can be deducted from the income as an expense that results in lower effective tax rate. Each canton has its own tax laws, tariffs, tax rates as well as exemptions.

They found interesting differences between Swiss cantons as follows:
Findings

11% cantonal authorities

58% cantonal authorities
31% cantonal authorities

Mistakes were in disfavor of tax payers
Mistakes were in favor of tax payer
Mistakes were neither disadvantageous nor advantageous

Later the tax authorities contracted with the taxpayers made mistakes in different ways.
Phoned the concerned and asked how the mistakes occurred

54% cantons

Sent a letter to the taxpayer with 50% standard format
100% cantons

Then the tax authorities corrected the returns and the impact of the treatment of taxpayers was judged. It was found that friendly and courteous treatment has a stronger dampening effect on tax evasion. Moreover, Swiss citizens are treated more respectfully by the tax authority in cantons with more strongly developed citizens’ participation rights. 13. Tax Compliance as a result of Psychological Tax Contract: Bangladesh Perspective
Although this is an unanswered puzzle that why taxpayer pay tax, but it is true in great extent that psychological tax contract between the taxpayer and tax authority plays a vital role in higher tax compliance. And also if effective incentives along with responsive regulation towards can be employed then it also results in higher tax compliance. This article is prepared on the basis of study in developed country. Although that tax law, subjects and tax treatment culture may be different but the ways of creating and maintaining psychological tax treatment are same around the world irrespective of the tax jurisdiction. If there is a contractual relationship in both parties then both will be conscious about their own duties and responsible. In Bangladesh such kind of contractual relationship has not yet been established. There is severe lack of respectful behavior from the tax authority towards taxpayer. And culture to pay right amount of tax has not abundant in Bangladesh. And the corruption and uncooperative behavior from the tax authority also play a vital role to evade and avoid in Bangladesh. In addition our government fails to justify about payment of tax by taxpayer. Because we see that every field of the government has filled with corruption and wastage of money occurs recklessly. These all matters result in deterring creating contractual relationship between tax payer and tax authority and ultimately resulting in higher noncompliance.

14. Conclusion
A fundamental result of the tax evasion literature is that it is still not fully resolved why people pay taxes, given the rather low levels of fines and auditing probabilities. Tax morale is a function of (1) the fiscal exchange where taxpayers get public services for the tax prices they pay, (2) the political procedures that lead to this exchange and (3) the personal relationship between the taxpayers and the tax administrators. The study in Switzerland summarized in the article provided by Feld and Frey indicates that the treatment of tax authorities systematically affects the taxpayers’ morale. The willingness to pay taxes in turn affects the cost of raising taxes. The study also provides a contractual relationship between taxpayers and the state. Another arguments provided by Ayres and Braithwaite also suggest that genuinely rewarding taxpayers in an exchange relationship will increase tax compliance while arrangement of punishment should be considered. The theoretical tax contract has the ability to bridge economics, law and policy.

Reference 1. LARS P. FELD and BRUNO S. FREY (2007) “Tax compliance as the Result of a Psychological Tax Contract: The Role of Incentives and Responsive Regulation” 2. Scholes, Myrons S.; Wolfson, Mark A.; Erickson Merle; Maydew Edward L. (Taxes and Business Strategy; Second Edition).