Comparing Direct and Indirect Taxation: The Influence of Framing on Tax Compliance
Watrin, Christoph, Ullmann, Robert, The European Journal of Comparative Economics
The idea of a consumption-based tax system has gained ever greater attention in tax policy debates of recent years. In the European Union (EU), most of the ten states that became EU members in May 2004 rely more on a value-added tax than on a corporate income tax. Furthermore, these states generally have lower corporate income tax rates than do the old EU member states. This new tax structure within the EU has given rise to much competition among the old and new EU member states with regard to both tax rates and structure of the tax system. In Germany, for example, the Tax Reform Act 2008 reduced the overall corporate tax rate from about 40 to about 30 percent. Almost at the same time, the government has raised the value-added tax rate from 16 to 19 percent, thereby increasing the importance of indirect taxes in the overall tax system. The United States Congress also is currently debating the Fair Tax Act of 2007 (H.R.25), which is a proposal to repeal the income tax and other current federal taxes, such as the estate and gift tax, and implement a national sales tax instead.
In public finance theory, the efficiency effects of a consumption tax in comparison to an income tax have been discussed for many years. Primary arguments for a general consumption tax are that it has less negative effects on labor supply than the income tax and that it interferes less with the choice between present and future consumption. A consumption tax further increases the part of the national income saved, and thus leads to more capital formation and higher economic growth (Musgrave and Musgrave (1989)). The major argument in favor of income taxation is generally that it is more adequate for the redistribution of income between income groups (Saez (2004)).
However, the design of the optimal tax system depends not only on considerations about efficiency and equity, but also on fiscal administration and enforcement costs. In this paper we present a new insight in compliance differences between divergent framings of the tax payment decision. Our research is rooted in the notion of behavioral public finance, which implies that behavioral effects must be considered in a well designed tax system (McCaffery and Slemrod (2006a)). In particular, we compare the tax payment decision between an income tax declaration scheme that has the possibility to underdeclare income and a consumption tax scheme with the possibility of buying a certain good either on the legal market, or on the black market where taxes on consumption are not levied.
For fiscal authorities, noncompliance, both in consumption and income tax, is a great concern. However, experimental research on the behavioral aspects of noncompliance has focused on income tax evasion, as summarized for instance by Alm (1991) and Andreoni et al. (1998). There is still little behavioral work on noncompliance in other areas of taxation (Webley et al. (2006)). Given the broad utilization of indirect taxation by governments around the world, this discrepancy is remarkable. To our knowledge, our study is the first work to explicitly focus on the behavioral differences in noncompliance between income and consumption tax.
In this study we develop an experimental design for the comparative analysis of compliance in consumption and income tax settings. The advantages of experimental work in the field of noncompliance are evident by the very nature of the problem of tax evasion, since noncompliance can only be observed with a high probability of error. Furthermore, our design allows us to explicitly control for the key determinants of compliance, namely the tax rate, detection probability, effectiveness of government spending, and penalty fees. It further enables us to control for omitted variables that are constant between the two tax framings. Hence, in our experimental design any differences in compliance can be attributed to a potential behavioral effect, that is, any combination of omitted variables inconsistent between the two tax payment framings. …