Gary Becker, the Nobel Laureate in economics, developed an elegant model of tax evasion based on economic factors. He contended that tax evasion was determined by the tradeoff between tax rates and the cost of punishment for noncompliance. Higher tax rates increase the incentive to cheat as one saves more money from evasion, while the cost of noncompliance deters avoidance. However, both these factors differ dramatically across countries. For example, in the United States cheating on taxes is a criminal offence and many famous personalities have been imprisoned as a consequence. In Switzerland, it is a civil offense: they levy a fine, then send you back to work, in order to earn and pay.
My argument here is that economic factors are not sufficient to explain tax evasion. Some Scandinavian countries with high tax rates and comfortable prisons have low tax evasion. Something else must be at work. My thesis is that the psychological factor of "citizen trust" is an important determinant in explaining the pervasiveness of tax evasion in countries such as India.
With respect to taxation, citizens need to sense three types of trust:
- The taxes levied will be used to pay for valued services.
- Their fellow citizens will pay their due share.
- There is a fair process for revenue collection.
Low tax base
The problem in India, where estimates show only 1% of the population pays income tax, is that the trust of citizens on all these three dimensions is low. India compares poorly from this standpoint with the United States, the United Kingdom and Switzerland, three other countries that I have lived in.
Providing services that individuals cannot procure for themselves – infrastructure, law and order, and the like – is a fundamental duty of governments. Taxes are necessary for this. While governments will always be inefficient, because they are spending someone else’s money rather their own, it is a question of how inefficient they are.
In the Indian context, we see a crisis in trust between citizens and the government. While total revenue collection in the country over the past decade has grown by leaps and bounds, citizens do not see any tangible effects on their lives. For example, roads are worse, public transportation is broken, the police are viewed as widely corrupt, and government schools and hospitals are always the last resort. Consequently, Indians do not see their taxes being used efficiently.
The second dimension of trust is the belief that your fellow citizens will pay their due share. In India the perception is that the largest tax offenders go scot free, while the more honest or compliant individuals and enterprises are pursued aggressively. To many, it seems there is a penalty for being honest. This is a problem of enforcement.
The third trust factor is about there being a fair process of revenue collection. What I have found in my research is that trust is determined by perceptions of "outcome fairness" and "procedural fairness". More interestingly, my research indicates that outcome fairness (e.g., tax rates) will be less of a determinant of citizens’ trust than procedural fairness.
Plan for change
A fair process incorporates six dimensions. To improve these should be the agenda for tax authorities.
- Bilateral Communication: Power over others often means that we listen less to them and our communication becomes one-sided. Two-way communication that engages citizens and allows them to give suggestions and complaints helps build trust.
- Impartiality: This has to do with consistency of policies and their application over time. While everyone cannot be treated identically, the system can be more equitable. A lot of the taxation issues that multinationals are facing in India are linked to this aspect of justice. It is impossible to plan without consistent policies.
- Refutability: The ability to appeal against tax decisions and have them resolved in a fast and cost-efficient manner is crucial. This is a huge problem in India, where the legal system is painfully slow in resolving disputes.
- Explanation: That means providing citizens with a coherent rationale for decisions and policies, and it calls for greater transparency. The more power we have, the less we feel the need to explain our decisions. But research indicates that the same decision with an explanation attached is seen as fairer than one without.
- Familiarity: An understanding of the local conditions under which businesses operate is necessary. Think of service tax and the small business unit where both husband and wife work punishing hours. Perhaps they have a turnover of Rs 10 million and a profit of Rs 1 million. Now, with the service tax implication, they have to hire a new person and do lots of paperwork. The system must have empathy for such folks, which is why small business owners in countries such as the United States and the United Kingdom are exempted from many regulations and taxes, or have to comply with a simple process that dramatically reduces filing requirements.
- Interactional Justice: You have to treat people with courtesy and respect. For example, in Singapore you can pay customs duty on wine by presenting your credit card and filling out a form on an automated machine. Often, collections increase if the process is easier, faster and respectful.
These six principles are the levers to help improve the citizen’s trust in the tax system. Public trust is one of the most precious assets that a country can have. It is the cornerstone of effective governance, the main ingredient to promote economic growth and social progress.
As Ralph Waldo Emerson said, “Our distrust is very expensive.”
Nirmalya Kumar is a visiting professor of marketing and London Business School and distinguished Fellow at INSEAD Emerging Markets Institute