THE administration of a tax system is, in itself, a costly exercise. But ensuring taxpayer compliance with tax laws is an added burden.
Tax authorities sometimes have to incur costs on such enforcement activities as audits of taxpayers, imposition and recoveries of penalties and prosecution for non-compliance.
The true cost of collection must therefore include both administrative costs and costs associated with compliance. In addition, tax disputes arising out of non-compliance lead to unnecessary and sometimes frivolous litigation. The potential tax revenues stuck in litigation represent a real cost to the economy. The need for setting up an effective mechanism for tax dispute resolution is nearly as pressing as that of designing an optimal tax system.
Compliance costs depend on a wide range of factors such as the complexity of the tax and that of tax laws, characteristics of the tax base, tax structure and tax rates, frequency of reform and reorganisation and efficiency of the tax authority.
Taxes should, therefore, be kept as simple and stable as possible. Modern tax systems tend to rely on market transactions to ensure maximum compliance. This in turn, however, involves costs associated with extensive withholding and information reporting requirement.
Non-compliance with tax laws refers to both evasion and avoidance. A tax is deemed to have been evaded when individuals deliberately fail to comply with their tax obligations, threatening the capacity of the public sector to function. Tax avoidance, on the other hand, is the understatement or reduction in the tax payable by a taxpayer.
There are two basic factors that facilitate non-compliance. First, non-compliance occurs because the variables that define the tax base, such as income, sales, revenues, wealth etc, are often not easily ‘observable’. An individual’s real tax base cannot then be ascertained unless costs are incurred on detection through audits etc.
Second, non-compliance is sometimes facilitated by interpreting a tax law in a way which is favourable to the individual or structuring a transaction in such a way that it minimises tax payments. In both cases, it is the complexity of tax laws that creates a window of opportunity to evade taxes.
An essential corollary to this dilemma is the fact that tax evasion and avoidance is a phenomenon associated most often with direct taxes. As a consequence, the already skewed distribution of income and wealth is further accentuated resulting in an adverse impact on growth and employment. We should also mention the fact that indirect taxes are relied on precisely because of the ease with which compliance can be ensured. In fact, the distortions caused by the imposition of regressive taxes on consumption is, once again, a real and measurable cost to the economy.
Complexity of tax laws can be defined as laws whose understanding and interpretation require specialised knowledge. Complexity sometimes results from the fact that tax laws are used to accomplish multiple goals, of which revenue collection happens to be one.
In addition, as the economy becomes increasingly complex, tax laws also assume complexity. Complex laws are usually associated with higher costs to both the tax authorities and taxpayers. These costs rise when the complexity of laws rises. It is also a source of tax disputes.
Tax disputes arise ultimately from ambiguity and complexity of tax laws. Not only does complexity raise the number of disputes but the cost of audits that do not result in detecting tax evasion also rises in direct proportion.
The decision by the tax authorities to carry out an audit is in effect a decision to initiate new tax disputes because it can be assumed that the authorities have a probability of detecting non-compliance.
However, the probability of detecting non-compliance is not random and audit cases should be based on a careful selection of those taxpayers where the probability of the expected benefit (larger revenue) exceeds its costs.
In a random selection of audit cases, the probability of detecting evasion decreases considerably and audits that do not result in detecting tax evasion also rise. In looking at tax disputes, the tax authority’s goal should be to maximise the total amount it recovers from all taxpayers it audits, net of its disputing costs.
Most tax disputes are compounded by an emphasis on institutional and procedural rules governing enforcement policy. It must be understood, however, that taxpayers’ stance on tax compliance is influenced by many other factors such as 1) disposition towards public institutions and public functionaries; 2) perceived fairness of the taxes; 3) prevailing social norms and attitudes; 4) chances of detection and punishment; and 5) complexity of tax laws.
Thus the normative perception of the taxpayer is just as important as other factors and tax compliance is facilitated by an equitable tax system. The standard normative framework for evaluating tax policy assumes that the best tax system is one that increases citizens’ welfare as they perceive it. Enforcement of tax laws must take into account taxpayers’ morale and the ease with which compliance can be accomplished.
The adoption of a comprehensive concept of cost gives us valuable insights into tax systems. First, the optimal mix of tax instruments cannot be determined by looking at a subset of the cost of revenue collection such as, for example, administrative costs. A tax instrument that looks easy to design and administer, may be excessively costly when it comes to compliance.
Second, when making incremental policy adjustments, it is the marginal costs that matter and not average or total costs.
Third, enforcement activity by tax authorities is a true resource cost to society, but any additional tax revenues that such activity brings is not a resource gain. It is a transfer from private citizens. It is, therefore, desirable to restrict the proliferation of enforcement activity. Attempting to maximise tax revenues net of only administrative costs is misleading because it ignores the high level of enforcement costs.
The writer is a professor of economics at a private university in Karachi.