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Does fairness matter in tax reporting behavior?
Journal of Economic Psychology 23 (2002) 771–785 www.elsevier.com/locate/joep
Does fairness matter in tax reporting behavior? Chung Kweon Kim
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School of Business and Administration, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong Received 30 October 1999; accepted 24 July 2002
Abstract Experimental results show that taxpayers who receive no public transfer generally perceive their exchange equity with the government to be less equitable than taxpayers who receive a public transfer. Furthermore, the effect of the public transfer on reported income depends on the extent to which the taxpayers use the perception of equity in their tax reporting decisions. Subjects who perceive equity to be important in their tax reporting decisions report more income when they receive a public transfer, but report less income when they receive no public transfer, as predicted by equity theory. In contrast, subjects who perceive equity to be less important in their tax reporting decisions act directionally consistent with the economic effect. That is, taxpayers who receive no public transfer tend to report more income than those who receive a public transfer. Ó 2002 Elsevier Science B.V. All rights reserved. PsycINFO classification: 2320; 2360 JEL classification: C91; D63; H26 Keywords: Tax compliance; Exchange equity; Fairness; Experiment; Public transfer
1. Introduction There is a growing consensus in the tax compliance literature that the fairness of an economic system plays an important role in tax reporting behavior. In this paper, fairness is limited to the taxpayerÕs perception of exchange equity with the
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government. Recent analytical models predict that compliance decreases with an increase in the taxpayerÕs share in public goods financed by tax revenue when the taxpayer assumes that their behavior leaves the total supply of public goods unchanged (Cowell, 1990, 1992; Cowell & Gordon, 1988; Falkinger, 1988). The economic effect of the public goods predicted by the analytical models, however, is not only counterintuitive (Cowell, 1992) but also poor in explaining empirical evidence. Alm (1991), among others, has emphasized the need for a broader approach, arguing that expected utility models are generally incapable of explaining existing observations. In contrast, equity theory predicts that a given level of tax payments, as the increase in public goods improves the taxpayerÕs perception of exchange equity, the taxpayer will be less likely to participate in tax evasion. Thus, the equity effect of the public goods results in more compliance as the level of public goods increases. In particular, field empirical and experimental results are rather consistent in relation to the equity effect. Using 148 audited tax returns for self-employed Jamaican taxpayers for a three-year period from 1980 to 1982, Alm, Bahl, and Murray (1993) show that marginal payroll tax benefits lower the probability of income underreporting. Although their result seems to be consistent with the equity effect, they did not provide any theoretical support for the result. Similar results have been reported in experimental studies (Alm, Jackson, & McKee, 1992a,b; Alm, McClelland, & Schulze, 1992; Becker, Buchner, & Sleeking, 1987), in which subjects report more income when they receive public goods than when they do not. Becker et al. (1987) test the effect of public transfer payments on tax evasion by using an experimental setting in which participants receive transfers as a predetermined share of the total expected tax payments. Whilst the negative correlation between the propensity to evade taxes (whether tax evasion occurs or not) and transfer payments is consistent with the equity effect, the findings may be plagued by such problems as multiple forms of perceived inequity, the endogeneity of income, and the uncertainty of audit probability with loaded tax terms. As subjects have to call upon their personal tax experience to fill the missing context (that is, audit probability), the experiment might have lost control to some extent. Several experimental studies by Alm and his coauthors (Alm et al., 1992a,b; Alm et al., 1992) also show that an increase in public goods increases the subjectsÕ compliance, but the interdependence among taxpayers in providing the public goods makes it difficult to conclude whether such an increase is due to the economic effect of the public goods, the equity effect of the public goods, or a combination of the two. To summarize, it has not been possible in previous experimental studies to isolate the equity effect from the economic effect of public goods on reported income. Survey results show that there is a group of taxpayers whose reporting behavior is mainly affected by the perceived equity of the tax system (Harris & Associates, Inc., 1988; Wallschutzky, 1984; Yankelovich, Skelly, & White, 1984). These results indicate that the effect of perceived equity on tax reporting can differ from taxpayer to taxpayer. Falkinger (1995) shows that the amount of tax that a person evades decreases (remains constant, increases) with perceived equity if only if the personÕs absolute risk aversion increases (remains constant, decreases) with perceived equity. The taxpayer whose absolute risk aversion increases with perceived equity is equivalent to the
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taxpayer group whose reporting behavior is mainly affected by the equity in the survey results mentioned above. Cuccia (1994) finds that the effect of penalty threats differ not only in strength but also in direction across paid tax preparer types (CPAs from the Big Six accounting firms vs. other non-CPA commercial tax preparers). An increase in preparer penalty results in more aggressive positions in the taxpayerÕs favor recommended by CPAs who perceive the increased penalty as a threat to the freedom of exercising oneÕs expert judgment. He concludes that a purely economic model is descriptive only for non-CPAs. The survey results together with CussiaÕs finding call for the need to consider different taxpayer types in analyzing empirical data as well as in designing experiments. The primary purpose of this paper is to experimentally test the predictions that increased public transfer will increase compliance when fairness is the main factor in the compliance decision, and will decrease compliance when the economic effect dominates the decision. Experimental results show that taxpayers who receive no public transfer generally perceive their exchange equity with the government to be less equitable than taxpayers who receive a public transfer. Furthermore, the effect of the public transfer on reported income depends on the extent to which the taxpayers use the perception of equity in their tax reporting decisions. Subjects who perceive equity to be important in their tax reporting decisions report more income when they receive a public transfer, but report less income when they receive no public transfer, as predicted by equity theory. In contrast, subjects who perceive equity to be less important in their tax reporting decisions act directionally consistent with the economic effect. That is, taxpayers who receive no public transfer tend to report more income than those who receive a public transfer. The remainder of this paper is organized as follows. Both economic and equity theories are discussed in Section 2 to develop competing hypotheses. The experimental design and procedures are described in Section 3. Section 4 presents the experimental results. Finally, Section 5 discusses the contributions and limitations of the paper.
2. Theory and hypothesis developments 2.1. Economic theory A simple economic model incorporating a public good is developed in this section based on the work of Yitzhaki (1974). However, to allow an unambiguous and testable economic prediction with respect to the effect of public goods on reported income, our analysis is limited to a public good with the following characteristics: (a) the public good takes the form of a cash transfer from the government (hereafter called the public transfer), which is used in most tax compliance experiments; and (b) the level of the public transfer received by a taxpayer is independent of both their income and tax payment. The second characteristic assumes that each tax evader acts as though their anti-social behavior leaves the total supply of public goods unaffected (Cowell, 1992; Gottlieb, 1985). The individual taxpayer has a utility function with their wealth as the only argument. The taxpayerÕs problem is to choose reported income X to maximize the
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expected utility, as EU ¼ ð1 pÞU ðY Þ þ pðZÞ, where U is taxpayerÕs utility function, U 0 > 0 and U 00 < 0; X is reported income; Y ¼ W hX þ F : after-tax income if not audited; Z ¼ W hX phðW X Þ þ F : after-tax income if audited; F is public transfer independent of the taxpayerÕs actual tax payments; p is probability of audit; W is actual taxable income; h is tax rate; p is penalty rate. Based on the above model, we obtain Proposition 1 under the conventional assumptions of a proportional penalty system in which the fine for underreporting is proportional to unpaid tax, and of decreasing absolute risk aversion (hereafter DARA). The intuition underlying Proposition 1 is straightforward: as the public transfer (F) increases, the taxpayer with DARA becomes wealthier, and is willing to take greater risks by reporting less income. The proof is available upon request. Proposition 1. A taxpayer with DARA will report less income as the public transfer (F) increases. 2.2. Equity theory Equity theory (Adams, 1965; Lewis, 1982; Walster, Walster, & Berscheid, 1978) deals with two issues: what is perceived to be equitable, and how people act upon this perception of equity. With respect to the first issue, a relationship is defined as equitable when all participants receive equal relative gains from the relationship, which represents the difference between the participantÕs contribution to and rewards from the relationship. The second issue deals with the consequences of equity perception. Walster et al. (1978) predict that when individuals find themselves in inequitable relationships, they become distressed and attempt to restore equity either by altering their own or their counterpartsÕ output or input, or by convincing themselves that the inequitable relationship is, in reality, equitable. In the tax context, exchange equity refers to the perceived fairness of a taxpayerÕs exchange with the government: that is, what the taxpayer receives from the government in exchange for taxes paid (Spicer & Lundstedt, 1976). If taxpayers do not agree with the governmentÕs spending policies, or if they perceive that they are not obtaining a fair exchange from the government for their tax payments, then they are distressed, and report less income than taxpayers who perceive equity in their exchange with the government. 2.3. Hypotheses Equity theory predicts that participants evaluate their contribution to, and benefits from, the system to which they belong. Thus, the relative magnitudes of the contributions and benefits in their exchange relationship with the government affect participantsÕ perceptions of exchange equity. This prediction is stated in Hypothesis 1. Hypothesis 1. For a given tax rate and income, perceived exchange equity is lower among taxpayers who receive no public transfer than among those who receive a public transfer.
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For the effect of the public transfer on reported income, we predict two counterbalancing effects. That is, the public transfer has a negative economic effect on reported income through the increase in the taxpayerÕs wealth, but a positive equity effect through an increase in exchange equity. We also predict, as survey results indicate, that the relative magnitude of these two counterbalancing effects will differ across different taxpayer types. Proposition 1 predicts the compliance behavior of the taxpayers to whom fairness is not a major factor in compliance decision, demonstrating that increasing the amount of public transfer increases the taxpayerÕs total wealth and that, given the DARA assumption, the taxpayer will take greater risks by reporting less income. Proposition 1 leads to Hypothesis 2A below. In contrast, equity theory predicts the compliance behavior of those taxpayers to whom fairness is a major factor in compliance decisions. When taxpayers receive no public transfer, they perceive their exchange relationship with the government to be less equitable, and to rectify inequity they report less income than those who receive a public transfer. This prediction is hypothesized in Hypothesis 2B. Hypothesis 2A (Proposition 1). Given the DARA assumption, reported income is lower among taxpayers who receive a public transfer than among those who do not when their compliance decision is less affected by perceptions of equity. Hypothesis 2B (Equity theory). Reported income is higher among taxpayers who receive a public transfer than among those who do not when their compliance decision is affected by perceptions of equity. 3. Experiment 3.1. Design and procedures To test our hypotheses, we designed an experiment in which the level of public transfer was manipulated as a between-subjects factor with two levels (no public transfer vs. public transfer). Forty-six MBA students volunteered to participate in two sessions (the NPT and PT conditions), which were conducted on the same day. Twenty-two subjects were randomly assigned to the NPT condition and the remaining twenty-four subjects to the PT condition. The experiment lasted approximately 75 minutes. As the major purpose of the study was to examine the role of perceived exchange equity in tax compliance decisions, natural tax terms such as ‘‘taxable income’’, ‘‘audit probability’’, and ‘‘penalty’’ were used in the experiment because the tax reporting decision is not merely a simple gamble, and experiments with neutral terms are likely to omit contextual factors that may be important in determining tax reporting behavior. Cowell (1992) emphasizes the importance of natural terms in tax experiments by arguing that as inequity is essentially a social phenomenon – involving the tax treatment, behavior or economic position of others – the context of the decision is crucial.
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Consistent with establishing perceived horizontal equity for all of the subjects, the instructions emphasized that each subject faced the same taxable income of 10,000 Lira and the same tax rate of 40% in each period. The audit probability was 20% in each period and the penalty rate was 100% of the tax evaded, so that any subject who was detected underreporting income had to pay the amount of tax underreported plus a penalty equal to 100% of the underreported tax. The instructions also explained the underlying public transfer system. Specifically, the instructions for the NPT condition stated that all participants received no government services in exchange for taxes paid. On the other hand, the instructions for the PT condition stated that all participants received the same level of government services in exchange for taxes paid. The government services were operationalized as a transfer of 4000 Lira from the government to the taxpayer, which was independent of the taxpayerÕs and other subjectsÕ actual tax payments. The amount of the public transfer was set at the expected tax payment (assuming honest reporting), which equaled the product of each subjectÕs actual taxable income (10,000 Lira) times the tax rate (40%). The generalizability problem of using such natural terms will be discussed in Section 5. After the subjects reviewed the instructions, a practice period was conducted to familiarize them with the experimental procedures. The subjects were informed that their performance in the practice period would not affect their payment. During the experiment, the subjectsÕ task was to choose how much of their 10,000 Lira taxable income to report in each period. Once the decisions were transferred to the experimenter, the audit process was conducted. The audit process randomly selected subjects to be audited by drawing numbered chips from a container with one chip for each subject. The audit resulted in perfect detection of any unreported income for those subjects who were audited. Whilst each subject knew whether they were detected for underreporting, they did not know the outcome for any other subject. As all of the parameters were fixed throughout the experiment, the subjects simply repeated the same task in each of the eight periods. At the end of the experiment, one of the eight periods was randomly selected for payment. The Lira earned in the selected period was converted at a rate of $1.00 per 1000 Lira. Because each period had an equal probability of being selected, this payment scheme produced the same incentives in each period for subjects to choose how much income to report. The payment scheme was explained to the subjects before the periods began. After the payment period was selected, the subjects completed the risk preference measurement instrument originally used by Moser, Evans, and Kim (1995). Risk preferences were measured to test whether subjects were risk averse, and whether there was any significant differences in risk preferences between the NPT and PT conditions. The risk preference measurement instrument directed subjects to choose between a sure thing that paid them 1000 Lira and a series of 15 lotteries with various probabilities of winning 2000 Lira. For analytical purposes, subjects who chose the lottery in less than eight of the 15 cases were classified as risk averse, subjects who chose the lottery in eight cases were classified as risk neutral, and subjects who chose the lottery in more than eight cases were classified as risk seeking. Once the subjects
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made their 15 choices, one of the 15 choices was randomly selected for payment by drawing a chip from a container holding chips numbered 1–15. For the item selected for payment, if a subject had chosen the sure thing, they received 1000 Lira. If the subject had chosen the lottery for the randomly selected item, their payment depended on the result of the lottery. The lottery for the selected item was conducted by drawing a chip from a container holding 100 chips numbered 1–100, which represented the probability of winning the lottery. Thus, if the number that appeared on the randomly selected chip was lower than the specified probability of winning the lottery for the selected item, then subjects who chose the lottery won 2000 Lira; otherwise, they won nothing. The subjects also completed a post-experimental questionnaire, and responded to questions that assessed the effectiveness of certain experimental controls and manipulations. The question regarding the level of government services provided a manipulation check on the public transfer variable. The questions regarding the income and tax rate experienced by other taxpayers were included to check whether horizontal equity was adequately controlled. Perceptions of exchange equity were measured by asking the subjects to rate the fairness of their exchange of taxes paid for government services received. To measure this perception, a seven-point scale was used, ranging from ‘‘Not fair at all’’ (0) to ‘‘Very fair’’ (6). The midpoint was defined as ‘‘Somewhat fair’’ (3). This rating was measured to test the effect of public transfer on perceived exchange equity as predicted in Hypothesis 1. The subjects were also asked to rate on a seven-point scale the degree to which their perception of the fairness of their exchange with the government affected their decision as to how much income to report to the government. The endpoints were labeled ‘‘No effect at all’’ (0) and ‘‘Very significant effect’’ (6), whilst the midpoint was labeled ‘‘Moderate effect’’ (3). This rating was used to classify the subjects into two groups. Those subjects who chose scale 3 or higher were classified as the ‘‘High Use of Equity’’ group (hereafter the HU group) and those subjects who chose scales less than 3 were classified as the ‘‘Low Use of Equity’’ group (hereafter the LU group). Similar attempts at classification were made by Chang, Nichols, and Schultz (1987), who separated subjects depending on whether they perceived that tax payment was a loss or a reduced gain, and, based on the separation, supported the prospect theory prediction in tax reporting. Hypotheses 2A and 2B are separately tested in relation to the LU group and the HU group respectively. The instructions and the post-experimental questionnaire are available upon request.
4. Results 4.1. Manipulation checks Data from the post-experimental questionnaire show that all of the subjects correctly identified the level of the public transfer that they received, which indicates that the manipulation of the public transfer was successful. The questions regarding other subjectsÕ income and tax rates were asked to check whether horizontal equity
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was effectively controlled. Only two subjects answered both questions incorrectly, which indicated that the control of horizontal equity was generally successful. 4.2. Hypothesis tests Hypothesis 1 predicts that perceived exchange equity is lower for taxpayers who receive no public transfer than for those who receive a public transfer. Hypothesis 1 is supported by the result that the subjectsÕ ratings of exchange equity in the NPT condition (mean ¼ 1.3) were significantly lower (t ¼ 4:03, two-tailed p ¼ 0:000) than the corresponding ratings in the PT condition (mean ¼ 3.9). Hypothesis 1 is also supported when subjects are separated into the LU group and the HU group based on their post-experimental questionnaire responses regarding the degree to which they used fairness perception in their tax reporting decisions. Twenty-eight subjects (61%) who rated less than 3 in the measurement were classified as the LU group, and the remaining eighteen subjects (39%) were classified as the HU group. The difference in perceived exchange equity is statistically significant between the NPT and the PT conditions for the LU group (t ¼ 2:07, two-tailed p ¼ 0:048) and the HU group (t ¼ 4:38, two-tailed p ¼ 0:000). Given the difference in perceived exchange equity between the NPT and PT conditions, the next question is whether this difference affects reported income. As Hypotheses 2A and 2B together imply a significant interaction between the public transfer conditions (NPT and PT) and the use of equity groups (LU and HU), an analysis of variance (ANOVA) was first performed to test whether the public transfer conditions affected the subjectsÕ reporting behavior according to their different considerations of exchange equity when they were making decisions. The ANOVA included the mean reported income over the eight periods (hereafter AVEALL) as a dependent variable, and public transfer with two levels (NPT and PT) and use of equity with two levels (LU and HU) as independent variables. The ANOVA results show that the interaction between public transfer and use of equity is significant (F ¼ 6:09, p ¼ 0:018). Fig. 1 depicts the interaction. The same pattern is held
Fig. 1. Mean reported income for all periods (AVEALL). NPT: no public transfer; PT: public transfer LU: low use of equity; HU: high use of equity.
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for two separate ANOVA tests conducted for the mean reported incomes across periods 1–4 (hereafter AVE1) and the mean reported income across periods 5–8 (hereafter AVE2). This significant interaction made it appropriate to perform separate tests for the LU group and the HU group. Hypothesis 2A predicts that due to the economic effect of the public transfer, the reported income will be lower in the PT condition than in the NPT condition among the LU group. Hypothesis 2B, in contrast, predicts that due to the equity effect of the public transfer, reported income will be higher in the PT condition than in the NPT condition among the HU group. Table 1 displays the mean reported income for the eight periods with the corresponding standard error of the mean for the NPT and PT conditions, separated by the LU and the HU groups. Fig. 2 depicts the mean reported income. For the LU group (n ¼ 28), the mean reported incomes in the PT condition are lower than the corresponding mean reported income in the NPT condition in six of the eight periods (periods 1, 2, 5, 6, 7, and 8). Whilst this pattern is directionally consistent with Hypothesis 2A, which predicts that reported income is lower among taxpayers who receive a public transfer than among those who do not, the difference is statistically significant only in the last period (t ¼ 1:99, two-tailed p ¼ 0:057). The directionally consistent but not statistically significant results hold for AVE1, AVE2, and AVEALL. Table 1 also shows that for the HU group (n ¼ 18) the differences in the mean reported incomes between the NPT and PT conditions in all of the eight periods are directionally consistent with Hypothesis 2B, which predicts that reported income is higher among taxpayers who receive a public transfer than among those who do not. Furthermore, these differences are statistically significant (two tailed p < 0:05) for five of the eight periods (periods 1, 2, 3, 7, and 8), and also for AVE1, AVE2, Table 1 Mean reported income amounts by use of equity and public transfer (in Lira) Periods
Low use (n ¼ 28) NPT (n ¼ 13) (1089)a (1016) (930) (962) (971) (951) (970) (991) (974) (969)
1 2 3 4 5 6 7 8 AVE1 AVE2
3446 3169 2538 2400 2615 2538 2585 2677 2888 2604
AVEALL
2746 (965)
High use (n ¼ 18)
PT (n ¼ 15)
Two-tailed t-statistics
NPTL (n ¼ 9)
PT (n ¼ 9)
Two-tailed t-statistics
2893 (837) 1760 (797) 2733 (933) 2600 (888) 1773 (750) 1307 (585) 1733 (796) 667 (386) 2497 (695) 1370 (514)
0.41 1.11 0.15 0.15 0.70 1.14 0.68 1.99 0.33 1.17
1467 (625) 1178 (551) 956 (437) 1956 (658) 2533 (1086) 1156 (543) 844 (300) 356 (185) 1389 (476) 1222 (363)
5689 5378 4867 3489 4644 2978 4422 2822 4856 3717
2.57 3.19 2.73 1.17 1.15 1.17 2.76 2.08 3.01 2.35
1933 (575)
0.75 (0.462)
1306 (394)
4286 (796)
(0.686) (0.279) (0.884) (0.880) (0.493) (0.266) (0.500) (0.057) (0.741) (0.253)
(1518) (1194) (1363) (1140) (1487) (1466) (1261) (1171) (1049) (999)
(0.020) (0.006) (0.015) (0.261) (0.268) (0.261) (0.014) (0.054) (0.008) (0.032)
3.36 (0.004)
NPT: no public transfer; PT: public transfer; LU: low use of equity; HU: high use of equity; AVE1: mean reported income across periods 1–4; AVE2: mean reported income across periods 5–8; AVEALL: mean reported income across periods 1–8. a The standard error of the mean in the parenthesis.
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Fig. 2. Mean reported incomes over periods 1–8. NPT: no public transfer; PT: public transfer LU: low use of equity HU: high use of equity.
and AVEALL. As the same results were observed when we used a nonparametric Mann–Whitney U test, we report the more familiar t-test results in Table 1. The experimental results strongly suggest that the two subgroups of subjects (the LU group and the HU group) respond differently to the level of the public transfer. Whilst the economic effect of the public transfer seems to be the primary factor in determining the report level for the LU group, the equity effect is obviously the driving force for the HU group. This conclusion can also be supported by the correlation analysis reported in Table 2. In the LU group, the correlations of AVE1, AVE2, and AVEALL to risk preference but not to perceived exchange equity are statistically significant, which implies that the subjects in that group behaved according to their risk tolerance. On the other hand, in the HU group, the correlations of AVE1, AVE2, and AVEALL are statistically significant to perceived exchange equity but not to risk preference, which implies that the HU subjects were mainly motivated by perceived exchanged equity rather than by economic incentives.
Table 2 Correlation coefficients Use of equity
AVEALL
AVE1
AVE2
FAIR
LU HU
)0.0768 0.5178a
)0.0021 0.4679a
)0.1537 0.4267a
RISK
LU HU
)0.5097b 0.2584
)0.5620b 0.4023a
)0.4255a 0.0154
LU: low use of equity; HU: high use of equity; AVE1: mean reported income across periods 1–4; AVE2: mean reported income across periods 5–8; AVEALL: mean reported income across periods 1–8; FAIR: perceived fairness; RISK: # of lotteries chosen. a Significant at p ¼ 0:05. b Significant at p ¼ 0:01.
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Table 3 Mean reported income amounts by public transfer and use of equity (in Lira) Periods
NPT (n ¼ 22)
PT (n ¼ 24)
LU (n ¼ 13)
HU (n ¼ 9)
Two-tailed t-statistics
LU (n ¼ 15)
HU (n ¼ 9)
Two-tailed t-statistics
(1089)a (1016) (930) (962) (970) (951) (970) (991) (974) (969)
1467 (625) 1178 (551) 956 (437) 1956 (658) 2533 (1086) 1156 (543) 844 (300) 356 (185) 1389 (476) 1222 (363)
1.40 1.52 1.34 0.35 0.06 1.12 1.45 1.92 1.21 1.14
(0.177) (0.144) (0.196) (0.733) (0.956) (0.276) (0.163) (0.069) (0.242) (0.267)
2893 (837) 1760 (797) 2733 (933) 2600 (888) 1773 (750) 1307 (584) 1733 (795) 667 (386) 2497 (695) 1370 (514)
5689 5378 4867 3489 4644 2978 4422 2822 4856 3717
1.76 2.62 1.33 0.61 1.92 1.23 1.90 2.10 1.95 2.31
1306 (394)
1.19 (0.249)
1933 (575)
4286 (796)
1 2 3 4 5 6 7 8 AVE1 AVE2
3446 3169 2538 2400 2615 2538 2585 2677 2888 2603
AVEALL
2746 (965)
(1518) (1193) (1363) (1140) (1487) (1466) (1261) (1170) (1049) (999)
(0.093) (0.016) (0.196) (0.545) (0.068) (0.230) (0.070) (0.047) (0.064) (0.030)
2.44 (0.023)
NPT: no public transfer; PT: public transfer; LU: low use of equity; HU: high use of equity; AVE1: mean reported income across periods 1–4; AVE2: mean reported income across periods 5–8; AVEALL: mean reported income across periods 1–8. a The standard error of the mean.
The equity effect becomes more obvious when the LU and HU groups are compared in each public transfer condition. As the taxpayers in each public transfer condition face the same economic incentives in making the reporting decision, any difference in reported income may be attributable to the different use of perceived equity. Table 3 shows that the HU group, on average, reported significantly higher income than the LU group in the PT condition, and that in the NPT condition the HU group reported lower income than the LU group, although this difference in the NPT condition becomes statistically significant only in the last period. When taxpayers consider exchange equity in their decisions, those who receive a public transfer (no public transfer) tend to comply more (less) than their counterparts in the same public transfer condition who do not consider exchange equity in their decisions. The results strongly imply that equity matters to certain taxpayers in making their reporting decisions. Some taxpayers evade more because they face inequity (that is, the HU group in the NPT condition). Yet more importantly, some taxpayers comply more because the system is equitable (that is, the HU group in the PT condition). As the responses of the subjects to whether their perceptions of fairness affected their decisions were collected after the experimental tasks, the use of fairness might simply have been a justification for tax evasion. If so, then taxpayers who rate the use of fairness higher would generally report income less. However, there was no significant correlation between the reported income and the use of fairness (p ¼ 0:857). Furthermore, the use of fairness resulted in higher compliance amongst the subjects in the PT condition of the HU group. These subjects reported significantly higher incomes than those subjects in the PT condition who did not seriously consider fairness in their decisions. We also tested whether the responses varied significantly over
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the NPT and PT conditions. The t-test results showed no difference (t ¼ 0:94, p ¼ 0:351) in the responses between the two conditions, and we can conclude that the task behavior of the subjects (which differed between conditions) did not affect their responses to the ex post questions. 4.3. Other analyses The mean number of lotteries chosen was 5.9 out of 15, which implies that subjects were generally risk averse. Furthermore, there is no significant difference in risk preferences between the NPT and PT conditions for all subjects (t ¼ 0:40, p ¼ 0:689), for the LU group (t ¼ 0:05, p ¼ 0:958), or for the HU group (t ¼ 0:65, p ¼ 0:525), which implies that any difference in mean reported income between the NPT and PT conditions for each of the LU group and the HU group cannot be attributed to systematic differences in the subjectsÕ risk preferences across the two public transfer conditions.
5. Discussion The design of this paper allows the direct examination of the role of exchange equity in tax reporting decisions by first providing an unambiguous prediction concerning the economic effect of the public transfer on reported income. In addition, the exchange equity of each taxpayer is manipulated by the provision of the public transfer, the level of which is independent of other taxpayers as well as individual reporting behavior, and the perception of exchange equity is then measured. Furthermore, the degree to which taxpayers use the perception of exchange equity in their tax reporting decisions is also measured. This paper provides additional insights into the mechanism of tax reporting behavior when the public transfer is provided. The findings reported here will contribute to the development of more adequate descriptive theory for a broader approach to tax compliance as well as future research design, especially in experimental studies. Moreover, the findings have policy implications. Policy makers may be able to reduce or prevent the negative effect on tax revenues of a particular level of taxation (due to increased evasion) by not only using economic sanctions, but also by explicitly demonstrating to taxpayers the benefits of their tax payments. These efforts may be more effective on those taxpayers whose behavior is more likely to be influenced by equity considerations, given the observation that a certain taxpayer group may be strongly affected by perceived exchange equity in their tax reporting decisions. Thus, it is beneficial for governments to understand the process by which taxpayers perceive fairness in their exchange relationships and, more importantly, to explore the characteristics of those taxpayers whose tax reporting behavior is more likely to be influenced by perceived exchange equity. There are several potential limitations regarding the generalizability of the findings in this paper. One possible limitation is the use of natural or loaded terms in the experiment. Alm (1991) claims that it is not possible to generalize beyond the lab-
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oratory unless neutral instructions are used. However, because the tax reporting decision is not necessarily a simple gamble, experiments with neutral terms may not be able to capture other factors such as tax perceptions, which appear to be important in determining reporting behavior in tax compliance research. Moreover, Fischer, Wartick, and Mark (1992) argue that the generalizability of lab experiments can be enhanced by making the setting more reflective of real-world settings. Thus, the use of natural terms may be an unavoidable limitation, especially in tax experiments. However, to minimize any loss of control due to the use of natural terms, our subjects were provided with information that was as complete and precise as possible regarding factors relevant to their tax reporting decisions. Alm et al. (1992) have shown that if complete and precise information is provided, then the use of loaded versus neutral instructions produces virtually identical results, which implies that subjects do not need to rely on their scripts to fill in missing information when sufficient relevant information is provided. A second limitation is that only eight repetitions of the experimental task were conducted. This might not have provided sufficient time for the behavior of subjects to stabilize. However, whilst increasing the number of repetitions might yield data of superior quality, it might also increase the danger that responses (including the apparent stability of responses) reflect boredom or fatigue rather than the behavior of interest (Davis & Swenson, 1988). Given the simple nature of the experimental task in this study, the cost would outweigh the benefit of increasing the number of repetitions. Moreover, for studies of comparative statistics such as this paper, the number of repetitions might not be critical unless ‘‘learning’’ affects each group differently. Furthermore, the patterns shown in Table 3 and Fig. 2 might imply that if there had been more repetitions, then the results would more likely have been stronger, especially for the LU group. Of course, we cannot rule out the possibility that the increase in income from the public transfer is not sufficient enough to induce a significant income effect, and this has potential as the basis of a future research agenda. Moreover, the task described in this paper does not represent an actual taxpayer decision problem, and only includes one income source. Whilst understating income is the only way to evade taxes in this experiment, the mis-statement of expenses is also widely used by real taxpayers as the method of tax evasion. Parameters such as audit probability and penalty were higher in the experiment than those in most actual tax settings. However, it may not be too high as, in practice, the discovery of fraud in one year often leads to the investigation of potential fraud in previous years. If Internal Revenue Services extend their investigations to the last five years (six years) of reporting, then the 20% audit rate in a one period game (as in the reporting situation of this study) is approximately equivalent to 4.4% (3.6%) per year in multi-period settings (as in real tax reporting situations). In addition, as there is no theory to predict an interaction between PT conditions and the level of audit probabilities, the ‘‘unrealistically high’’ audit rate cannot explain the experimental results. Finally, whilst the public transfer conditions are used as a between-subjects treatment in this study, using a within-subject treatment might result in more significant
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differences, as one condition can clearly be framed as a reference in terms of wealth level and perceived exchange equity. This is an open-ended question that can be addressed by future studies.
Acknowledgements I gratefully acknowledge the comments and suggestions of Henry Robben (Associate editor), two anonymous referees, Don Moser, Bill Waller and seminar participants at the HKUST. I am particularly grateful to Harry Evans III for his insightful guidance. I acknowledge the financial support of the Hong Kong University of Science and Technology.
References Adams, J. (1965). Inequity in social exchange. In L. Berkowitz (Ed.), Advances in experimental social psychology (2, pp. 267–299). New York: Academic Press. Alm, J. (1991). A perspective on the experimental analysis of taxpayer reporting. The Accounting Review, 66(3), 577–593. Alm, J., Bahl, R., & Murray, M. (1993). Audit selection and income tax underreporting in the tax compliance game. Journal of Development Economics, 42(1), 1–33. Alm, J., Jackson, B., & McKee, M. (1992a). Estimating the determinants of taxpayer compliance with experimental data. National Tax Journal, 45(1), 107–114. Alm, J., Jackson, B., & McKee, M. (1992b). Institutional uncertainty and taxpayer compliance. American Economic Review, 82(4), 1018–1026. Alm, J., McClelland, G., & Schulze, W. (1992). Why do people pay taxes? Journal of Public Economics, 48(1), 21–38. Becker, W., Buchner, H., & Sleeking, S. (1987). The impact of public transfer expenditures on tax evasion. Journal of Public Economics, 34(2), 243–252. Chang, O., Nichols, D., & Schultz, J. (1987). Taxpayer attitudes toward tax audit risk. Journal of Economic Psychology, 8, 299–309. Cowell, F. (1990). Cheating the Government. Cambridge, MA: MIT Press. Cowell, F. (1992). Tax evasion and inequity. Journal of Economic Psychology, 13, 521–543. Cowell, F., & Gordon, J. (1988). Unwillingness to pay. Journal of Public Economics, 36(3), 305–321. Cuccia, (1994). The effects of increased sanctions on professional tax preparers: integrating economic and psychological factors. The Journal of the American Taxation Association, 16, 41–66. Davis, J., & Swenson, C. (1988). The role of experimental economics in tax policy research. The Journal of the American Taxation Association, 40–59. Falkinger, J. (1988). Tax evasion and equity: a theoretical analysis. Public Finance, 43(3), 388–395. Falkinger, J. (1995). Tax evasion, consumption of public goods and fairness. Journal of Economic Psychology, 16, 63–72. Fischer, C., Wartick, M., & Mark, M. (1992). Detection probability and taxpayer compliance: A review of the literature. Journal of Accounting Literature, 11, 1–46. Gottlieb, D. (1985). Tax evasion and the prisonerÕs dilemma. Mathematical Social Sciences, 10(1), 81–89. Harris and Associates, Inc. (1988). 1987 Taxpayer Opinion Survey. New York: Internal Revenue Services. Lewis, A. (1982). The psychology of taxation. New York: St. MartinÕs Press. Moser, D., Evans, H., & Kim, C. (1995). The effects of horizontal and exchange inequity on tax reporting decisions. The Accounting Review, 70(4), 619–634. Spicer, M., & Lundstedt, S. (1976). Understanding tax evasion. Public Finance, 31, 295–305.
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Wallschutzky, I. (1984). Possible causes of tax evasion. Journal of Economic Psychology, 5, 371–384. Walster, E., Walster, G., & Berscheid, E. (1978). Equity: theory & research. Boston: Allyn and Bacon, Inc. Yankelovich, Skelly, White, Inc. (1984). Taxpayer Attitudes Survey: Final Report. Public Opinion Survey Prepared for the Public Affairs Division. New York: Internal Revenue Service. Yitzhaki, S. (1974). Income tax evasion: a note. Journal of Public Economics, 3, 2012.
Does fairness matter in tax reporting behavior? Chung Kweon Kim
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School of Business and Administration, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong Received 30 October 1999; accepted 24 July 2002
Abstract Experimental results show that taxpayers who receive no public transfer generally perceive their exchange equity with the government to be less equitable than taxpayers who receive a public transfer. Furthermore, the effect of the public transfer on reported income depends on the extent to which the taxpayers use the perception of equity in their tax reporting decisions. Subjects who perceive equity to be important in their tax reporting decisions report more income when they receive a public transfer, but report less income when they receive no public transfer, as predicted by equity theory. In contrast, subjects who perceive equity to be less important in their tax reporting decisions act directionally consistent with the economic effect. That is, taxpayers who receive no public transfer tend to report more income than those who receive a public transfer. Ó 2002 Elsevier Science B.V. All rights reserved. PsycINFO classification: 2320; 2360 JEL classification: C91; D63; H26 Keywords: Tax compliance; Exchange equity; Fairness; Experiment; Public transfer
1. Introduction There is a growing consensus in the tax compliance literature that the fairness of an economic system plays an important role in tax reporting behavior. In this paper, fairness is limited to the taxpayerÕs perception of exchange equity with the
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Tel.: +852-2358-7568; fax: +852-2358-1693. E-mail address: [email protected] (C.K. Kim).
0167-4870/02/$ - see front matter Ó 2002 Elsevier Science B.V. All rights reserved. PII: S 0 1 6 7 - 4 8 7 0 ( 0 2 ) 0 0 1 3 8 - 1
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government. Recent analytical models predict that compliance decreases with an increase in the taxpayerÕs share in public goods financed by tax revenue when the taxpayer assumes that their behavior leaves the total supply of public goods unchanged (Cowell, 1990, 1992; Cowell & Gordon, 1988; Falkinger, 1988). The economic effect of the public goods predicted by the analytical models, however, is not only counterintuitive (Cowell, 1992) but also poor in explaining empirical evidence. Alm (1991), among others, has emphasized the need for a broader approach, arguing that expected utility models are generally incapable of explaining existing observations. In contrast, equity theory predicts that a given level of tax payments, as the increase in public goods improves the taxpayerÕs perception of exchange equity, the taxpayer will be less likely to participate in tax evasion. Thus, the equity effect of the public goods results in more compliance as the level of public goods increases. In particular, field empirical and experimental results are rather consistent in relation to the equity effect. Using 148 audited tax returns for self-employed Jamaican taxpayers for a three-year period from 1980 to 1982, Alm, Bahl, and Murray (1993) show that marginal payroll tax benefits lower the probability of income underreporting. Although their result seems to be consistent with the equity effect, they did not provide any theoretical support for the result. Similar results have been reported in experimental studies (Alm, Jackson, & McKee, 1992a,b; Alm, McClelland, & Schulze, 1992; Becker, Buchner, & Sleeking, 1987), in which subjects report more income when they receive public goods than when they do not. Becker et al. (1987) test the effect of public transfer payments on tax evasion by using an experimental setting in which participants receive transfers as a predetermined share of the total expected tax payments. Whilst the negative correlation between the propensity to evade taxes (whether tax evasion occurs or not) and transfer payments is consistent with the equity effect, the findings may be plagued by such problems as multiple forms of perceived inequity, the endogeneity of income, and the uncertainty of audit probability with loaded tax terms. As subjects have to call upon their personal tax experience to fill the missing context (that is, audit probability), the experiment might have lost control to some extent. Several experimental studies by Alm and his coauthors (Alm et al., 1992a,b; Alm et al., 1992) also show that an increase in public goods increases the subjectsÕ compliance, but the interdependence among taxpayers in providing the public goods makes it difficult to conclude whether such an increase is due to the economic effect of the public goods, the equity effect of the public goods, or a combination of the two. To summarize, it has not been possible in previous experimental studies to isolate the equity effect from the economic effect of public goods on reported income. Survey results show that there is a group of taxpayers whose reporting behavior is mainly affected by the perceived equity of the tax system (Harris & Associates, Inc., 1988; Wallschutzky, 1984; Yankelovich, Skelly, & White, 1984). These results indicate that the effect of perceived equity on tax reporting can differ from taxpayer to taxpayer. Falkinger (1995) shows that the amount of tax that a person evades decreases (remains constant, increases) with perceived equity if only if the personÕs absolute risk aversion increases (remains constant, decreases) with perceived equity. The taxpayer whose absolute risk aversion increases with perceived equity is equivalent to the
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taxpayer group whose reporting behavior is mainly affected by the equity in the survey results mentioned above. Cuccia (1994) finds that the effect of penalty threats differ not only in strength but also in direction across paid tax preparer types (CPAs from the Big Six accounting firms vs. other non-CPA commercial tax preparers). An increase in preparer penalty results in more aggressive positions in the taxpayerÕs favor recommended by CPAs who perceive the increased penalty as a threat to the freedom of exercising oneÕs expert judgment. He concludes that a purely economic model is descriptive only for non-CPAs. The survey results together with CussiaÕs finding call for the need to consider different taxpayer types in analyzing empirical data as well as in designing experiments. The primary purpose of this paper is to experimentally test the predictions that increased public transfer will increase compliance when fairness is the main factor in the compliance decision, and will decrease compliance when the economic effect dominates the decision. Experimental results show that taxpayers who receive no public transfer generally perceive their exchange equity with the government to be less equitable than taxpayers who receive a public transfer. Furthermore, the effect of the public transfer on reported income depends on the extent to which the taxpayers use the perception of equity in their tax reporting decisions. Subjects who perceive equity to be important in their tax reporting decisions report more income when they receive a public transfer, but report less income when they receive no public transfer, as predicted by equity theory. In contrast, subjects who perceive equity to be less important in their tax reporting decisions act directionally consistent with the economic effect. That is, taxpayers who receive no public transfer tend to report more income than those who receive a public transfer. The remainder of this paper is organized as follows. Both economic and equity theories are discussed in Section 2 to develop competing hypotheses. The experimental design and procedures are described in Section 3. Section 4 presents the experimental results. Finally, Section 5 discusses the contributions and limitations of the paper.
2. Theory and hypothesis developments 2.1. Economic theory A simple economic model incorporating a public good is developed in this section based on the work of Yitzhaki (1974). However, to allow an unambiguous and testable economic prediction with respect to the effect of public goods on reported income, our analysis is limited to a public good with the following characteristics: (a) the public good takes the form of a cash transfer from the government (hereafter called the public transfer), which is used in most tax compliance experiments; and (b) the level of the public transfer received by a taxpayer is independent of both their income and tax payment. The second characteristic assumes that each tax evader acts as though their anti-social behavior leaves the total supply of public goods unaffected (Cowell, 1992; Gottlieb, 1985). The individual taxpayer has a utility function with their wealth as the only argument. The taxpayerÕs problem is to choose reported income X to maximize the
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expected utility, as EU ¼ ð1 pÞU ðY Þ þ pðZÞ, where U is taxpayerÕs utility function, U 0 > 0 and U 00 < 0; X is reported income; Y ¼ W hX þ F : after-tax income if not audited; Z ¼ W hX phðW X Þ þ F : after-tax income if audited; F is public transfer independent of the taxpayerÕs actual tax payments; p is probability of audit; W is actual taxable income; h is tax rate; p is penalty rate. Based on the above model, we obtain Proposition 1 under the conventional assumptions of a proportional penalty system in which the fine for underreporting is proportional to unpaid tax, and of decreasing absolute risk aversion (hereafter DARA). The intuition underlying Proposition 1 is straightforward: as the public transfer (F) increases, the taxpayer with DARA becomes wealthier, and is willing to take greater risks by reporting less income. The proof is available upon request. Proposition 1. A taxpayer with DARA will report less income as the public transfer (F) increases. 2.2. Equity theory Equity theory (Adams, 1965; Lewis, 1982; Walster, Walster, & Berscheid, 1978) deals with two issues: what is perceived to be equitable, and how people act upon this perception of equity. With respect to the first issue, a relationship is defined as equitable when all participants receive equal relative gains from the relationship, which represents the difference between the participantÕs contribution to and rewards from the relationship. The second issue deals with the consequences of equity perception. Walster et al. (1978) predict that when individuals find themselves in inequitable relationships, they become distressed and attempt to restore equity either by altering their own or their counterpartsÕ output or input, or by convincing themselves that the inequitable relationship is, in reality, equitable. In the tax context, exchange equity refers to the perceived fairness of a taxpayerÕs exchange with the government: that is, what the taxpayer receives from the government in exchange for taxes paid (Spicer & Lundstedt, 1976). If taxpayers do not agree with the governmentÕs spending policies, or if they perceive that they are not obtaining a fair exchange from the government for their tax payments, then they are distressed, and report less income than taxpayers who perceive equity in their exchange with the government. 2.3. Hypotheses Equity theory predicts that participants evaluate their contribution to, and benefits from, the system to which they belong. Thus, the relative magnitudes of the contributions and benefits in their exchange relationship with the government affect participantsÕ perceptions of exchange equity. This prediction is stated in Hypothesis 1. Hypothesis 1. For a given tax rate and income, perceived exchange equity is lower among taxpayers who receive no public transfer than among those who receive a public transfer.
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For the effect of the public transfer on reported income, we predict two counterbalancing effects. That is, the public transfer has a negative economic effect on reported income through the increase in the taxpayerÕs wealth, but a positive equity effect through an increase in exchange equity. We also predict, as survey results indicate, that the relative magnitude of these two counterbalancing effects will differ across different taxpayer types. Proposition 1 predicts the compliance behavior of the taxpayers to whom fairness is not a major factor in compliance decision, demonstrating that increasing the amount of public transfer increases the taxpayerÕs total wealth and that, given the DARA assumption, the taxpayer will take greater risks by reporting less income. Proposition 1 leads to Hypothesis 2A below. In contrast, equity theory predicts the compliance behavior of those taxpayers to whom fairness is a major factor in compliance decisions. When taxpayers receive no public transfer, they perceive their exchange relationship with the government to be less equitable, and to rectify inequity they report less income than those who receive a public transfer. This prediction is hypothesized in Hypothesis 2B. Hypothesis 2A (Proposition 1). Given the DARA assumption, reported income is lower among taxpayers who receive a public transfer than among those who do not when their compliance decision is less affected by perceptions of equity. Hypothesis 2B (Equity theory). Reported income is higher among taxpayers who receive a public transfer than among those who do not when their compliance decision is affected by perceptions of equity. 3. Experiment 3.1. Design and procedures To test our hypotheses, we designed an experiment in which the level of public transfer was manipulated as a between-subjects factor with two levels (no public transfer vs. public transfer). Forty-six MBA students volunteered to participate in two sessions (the NPT and PT conditions), which were conducted on the same day. Twenty-two subjects were randomly assigned to the NPT condition and the remaining twenty-four subjects to the PT condition. The experiment lasted approximately 75 minutes. As the major purpose of the study was to examine the role of perceived exchange equity in tax compliance decisions, natural tax terms such as ‘‘taxable income’’, ‘‘audit probability’’, and ‘‘penalty’’ were used in the experiment because the tax reporting decision is not merely a simple gamble, and experiments with neutral terms are likely to omit contextual factors that may be important in determining tax reporting behavior. Cowell (1992) emphasizes the importance of natural terms in tax experiments by arguing that as inequity is essentially a social phenomenon – involving the tax treatment, behavior or economic position of others – the context of the decision is crucial.
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Consistent with establishing perceived horizontal equity for all of the subjects, the instructions emphasized that each subject faced the same taxable income of 10,000 Lira and the same tax rate of 40% in each period. The audit probability was 20% in each period and the penalty rate was 100% of the tax evaded, so that any subject who was detected underreporting income had to pay the amount of tax underreported plus a penalty equal to 100% of the underreported tax. The instructions also explained the underlying public transfer system. Specifically, the instructions for the NPT condition stated that all participants received no government services in exchange for taxes paid. On the other hand, the instructions for the PT condition stated that all participants received the same level of government services in exchange for taxes paid. The government services were operationalized as a transfer of 4000 Lira from the government to the taxpayer, which was independent of the taxpayerÕs and other subjectsÕ actual tax payments. The amount of the public transfer was set at the expected tax payment (assuming honest reporting), which equaled the product of each subjectÕs actual taxable income (10,000 Lira) times the tax rate (40%). The generalizability problem of using such natural terms will be discussed in Section 5. After the subjects reviewed the instructions, a practice period was conducted to familiarize them with the experimental procedures. The subjects were informed that their performance in the practice period would not affect their payment. During the experiment, the subjectsÕ task was to choose how much of their 10,000 Lira taxable income to report in each period. Once the decisions were transferred to the experimenter, the audit process was conducted. The audit process randomly selected subjects to be audited by drawing numbered chips from a container with one chip for each subject. The audit resulted in perfect detection of any unreported income for those subjects who were audited. Whilst each subject knew whether they were detected for underreporting, they did not know the outcome for any other subject. As all of the parameters were fixed throughout the experiment, the subjects simply repeated the same task in each of the eight periods. At the end of the experiment, one of the eight periods was randomly selected for payment. The Lira earned in the selected period was converted at a rate of $1.00 per 1000 Lira. Because each period had an equal probability of being selected, this payment scheme produced the same incentives in each period for subjects to choose how much income to report. The payment scheme was explained to the subjects before the periods began. After the payment period was selected, the subjects completed the risk preference measurement instrument originally used by Moser, Evans, and Kim (1995). Risk preferences were measured to test whether subjects were risk averse, and whether there was any significant differences in risk preferences between the NPT and PT conditions. The risk preference measurement instrument directed subjects to choose between a sure thing that paid them 1000 Lira and a series of 15 lotteries with various probabilities of winning 2000 Lira. For analytical purposes, subjects who chose the lottery in less than eight of the 15 cases were classified as risk averse, subjects who chose the lottery in eight cases were classified as risk neutral, and subjects who chose the lottery in more than eight cases were classified as risk seeking. Once the subjects
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made their 15 choices, one of the 15 choices was randomly selected for payment by drawing a chip from a container holding chips numbered 1–15. For the item selected for payment, if a subject had chosen the sure thing, they received 1000 Lira. If the subject had chosen the lottery for the randomly selected item, their payment depended on the result of the lottery. The lottery for the selected item was conducted by drawing a chip from a container holding 100 chips numbered 1–100, which represented the probability of winning the lottery. Thus, if the number that appeared on the randomly selected chip was lower than the specified probability of winning the lottery for the selected item, then subjects who chose the lottery won 2000 Lira; otherwise, they won nothing. The subjects also completed a post-experimental questionnaire, and responded to questions that assessed the effectiveness of certain experimental controls and manipulations. The question regarding the level of government services provided a manipulation check on the public transfer variable. The questions regarding the income and tax rate experienced by other taxpayers were included to check whether horizontal equity was adequately controlled. Perceptions of exchange equity were measured by asking the subjects to rate the fairness of their exchange of taxes paid for government services received. To measure this perception, a seven-point scale was used, ranging from ‘‘Not fair at all’’ (0) to ‘‘Very fair’’ (6). The midpoint was defined as ‘‘Somewhat fair’’ (3). This rating was measured to test the effect of public transfer on perceived exchange equity as predicted in Hypothesis 1. The subjects were also asked to rate on a seven-point scale the degree to which their perception of the fairness of their exchange with the government affected their decision as to how much income to report to the government. The endpoints were labeled ‘‘No effect at all’’ (0) and ‘‘Very significant effect’’ (6), whilst the midpoint was labeled ‘‘Moderate effect’’ (3). This rating was used to classify the subjects into two groups. Those subjects who chose scale 3 or higher were classified as the ‘‘High Use of Equity’’ group (hereafter the HU group) and those subjects who chose scales less than 3 were classified as the ‘‘Low Use of Equity’’ group (hereafter the LU group). Similar attempts at classification were made by Chang, Nichols, and Schultz (1987), who separated subjects depending on whether they perceived that tax payment was a loss or a reduced gain, and, based on the separation, supported the prospect theory prediction in tax reporting. Hypotheses 2A and 2B are separately tested in relation to the LU group and the HU group respectively. The instructions and the post-experimental questionnaire are available upon request.
4. Results 4.1. Manipulation checks Data from the post-experimental questionnaire show that all of the subjects correctly identified the level of the public transfer that they received, which indicates that the manipulation of the public transfer was successful. The questions regarding other subjectsÕ income and tax rates were asked to check whether horizontal equity
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was effectively controlled. Only two subjects answered both questions incorrectly, which indicated that the control of horizontal equity was generally successful. 4.2. Hypothesis tests Hypothesis 1 predicts that perceived exchange equity is lower for taxpayers who receive no public transfer than for those who receive a public transfer. Hypothesis 1 is supported by the result that the subjectsÕ ratings of exchange equity in the NPT condition (mean ¼ 1.3) were significantly lower (t ¼ 4:03, two-tailed p ¼ 0:000) than the corresponding ratings in the PT condition (mean ¼ 3.9). Hypothesis 1 is also supported when subjects are separated into the LU group and the HU group based on their post-experimental questionnaire responses regarding the degree to which they used fairness perception in their tax reporting decisions. Twenty-eight subjects (61%) who rated less than 3 in the measurement were classified as the LU group, and the remaining eighteen subjects (39%) were classified as the HU group. The difference in perceived exchange equity is statistically significant between the NPT and the PT conditions for the LU group (t ¼ 2:07, two-tailed p ¼ 0:048) and the HU group (t ¼ 4:38, two-tailed p ¼ 0:000). Given the difference in perceived exchange equity between the NPT and PT conditions, the next question is whether this difference affects reported income. As Hypotheses 2A and 2B together imply a significant interaction between the public transfer conditions (NPT and PT) and the use of equity groups (LU and HU), an analysis of variance (ANOVA) was first performed to test whether the public transfer conditions affected the subjectsÕ reporting behavior according to their different considerations of exchange equity when they were making decisions. The ANOVA included the mean reported income over the eight periods (hereafter AVEALL) as a dependent variable, and public transfer with two levels (NPT and PT) and use of equity with two levels (LU and HU) as independent variables. The ANOVA results show that the interaction between public transfer and use of equity is significant (F ¼ 6:09, p ¼ 0:018). Fig. 1 depicts the interaction. The same pattern is held
Fig. 1. Mean reported income for all periods (AVEALL). NPT: no public transfer; PT: public transfer LU: low use of equity; HU: high use of equity.
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for two separate ANOVA tests conducted for the mean reported incomes across periods 1–4 (hereafter AVE1) and the mean reported income across periods 5–8 (hereafter AVE2). This significant interaction made it appropriate to perform separate tests for the LU group and the HU group. Hypothesis 2A predicts that due to the economic effect of the public transfer, the reported income will be lower in the PT condition than in the NPT condition among the LU group. Hypothesis 2B, in contrast, predicts that due to the equity effect of the public transfer, reported income will be higher in the PT condition than in the NPT condition among the HU group. Table 1 displays the mean reported income for the eight periods with the corresponding standard error of the mean for the NPT and PT conditions, separated by the LU and the HU groups. Fig. 2 depicts the mean reported income. For the LU group (n ¼ 28), the mean reported incomes in the PT condition are lower than the corresponding mean reported income in the NPT condition in six of the eight periods (periods 1, 2, 5, 6, 7, and 8). Whilst this pattern is directionally consistent with Hypothesis 2A, which predicts that reported income is lower among taxpayers who receive a public transfer than among those who do not, the difference is statistically significant only in the last period (t ¼ 1:99, two-tailed p ¼ 0:057). The directionally consistent but not statistically significant results hold for AVE1, AVE2, and AVEALL. Table 1 also shows that for the HU group (n ¼ 18) the differences in the mean reported incomes between the NPT and PT conditions in all of the eight periods are directionally consistent with Hypothesis 2B, which predicts that reported income is higher among taxpayers who receive a public transfer than among those who do not. Furthermore, these differences are statistically significant (two tailed p < 0:05) for five of the eight periods (periods 1, 2, 3, 7, and 8), and also for AVE1, AVE2, Table 1 Mean reported income amounts by use of equity and public transfer (in Lira) Periods
Low use (n ¼ 28) NPT (n ¼ 13) (1089)a (1016) (930) (962) (971) (951) (970) (991) (974) (969)
1 2 3 4 5 6 7 8 AVE1 AVE2
3446 3169 2538 2400 2615 2538 2585 2677 2888 2604
AVEALL
2746 (965)
High use (n ¼ 18)
PT (n ¼ 15)
Two-tailed t-statistics
NPTL (n ¼ 9)
PT (n ¼ 9)
Two-tailed t-statistics
2893 (837) 1760 (797) 2733 (933) 2600 (888) 1773 (750) 1307 (585) 1733 (796) 667 (386) 2497 (695) 1370 (514)
0.41 1.11 0.15 0.15 0.70 1.14 0.68 1.99 0.33 1.17
1467 (625) 1178 (551) 956 (437) 1956 (658) 2533 (1086) 1156 (543) 844 (300) 356 (185) 1389 (476) 1222 (363)
5689 5378 4867 3489 4644 2978 4422 2822 4856 3717
2.57 3.19 2.73 1.17 1.15 1.17 2.76 2.08 3.01 2.35
1933 (575)
0.75 (0.462)
1306 (394)
4286 (796)
(0.686) (0.279) (0.884) (0.880) (0.493) (0.266) (0.500) (0.057) (0.741) (0.253)
(1518) (1194) (1363) (1140) (1487) (1466) (1261) (1171) (1049) (999)
(0.020) (0.006) (0.015) (0.261) (0.268) (0.261) (0.014) (0.054) (0.008) (0.032)
3.36 (0.004)
NPT: no public transfer; PT: public transfer; LU: low use of equity; HU: high use of equity; AVE1: mean reported income across periods 1–4; AVE2: mean reported income across periods 5–8; AVEALL: mean reported income across periods 1–8. a The standard error of the mean in the parenthesis.
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Fig. 2. Mean reported incomes over periods 1–8. NPT: no public transfer; PT: public transfer LU: low use of equity HU: high use of equity.
and AVEALL. As the same results were observed when we used a nonparametric Mann–Whitney U test, we report the more familiar t-test results in Table 1. The experimental results strongly suggest that the two subgroups of subjects (the LU group and the HU group) respond differently to the level of the public transfer. Whilst the economic effect of the public transfer seems to be the primary factor in determining the report level for the LU group, the equity effect is obviously the driving force for the HU group. This conclusion can also be supported by the correlation analysis reported in Table 2. In the LU group, the correlations of AVE1, AVE2, and AVEALL to risk preference but not to perceived exchange equity are statistically significant, which implies that the subjects in that group behaved according to their risk tolerance. On the other hand, in the HU group, the correlations of AVE1, AVE2, and AVEALL are statistically significant to perceived exchange equity but not to risk preference, which implies that the HU subjects were mainly motivated by perceived exchanged equity rather than by economic incentives.
Table 2 Correlation coefficients Use of equity
AVEALL
AVE1
AVE2
FAIR
LU HU
)0.0768 0.5178a
)0.0021 0.4679a
)0.1537 0.4267a
RISK
LU HU
)0.5097b 0.2584
)0.5620b 0.4023a
)0.4255a 0.0154
LU: low use of equity; HU: high use of equity; AVE1: mean reported income across periods 1–4; AVE2: mean reported income across periods 5–8; AVEALL: mean reported income across periods 1–8; FAIR: perceived fairness; RISK: # of lotteries chosen. a Significant at p ¼ 0:05. b Significant at p ¼ 0:01.
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Table 3 Mean reported income amounts by public transfer and use of equity (in Lira) Periods
NPT (n ¼ 22)
PT (n ¼ 24)
LU (n ¼ 13)
HU (n ¼ 9)
Two-tailed t-statistics
LU (n ¼ 15)
HU (n ¼ 9)
Two-tailed t-statistics
(1089)a (1016) (930) (962) (970) (951) (970) (991) (974) (969)
1467 (625) 1178 (551) 956 (437) 1956 (658) 2533 (1086) 1156 (543) 844 (300) 356 (185) 1389 (476) 1222 (363)
1.40 1.52 1.34 0.35 0.06 1.12 1.45 1.92 1.21 1.14
(0.177) (0.144) (0.196) (0.733) (0.956) (0.276) (0.163) (0.069) (0.242) (0.267)
2893 (837) 1760 (797) 2733 (933) 2600 (888) 1773 (750) 1307 (584) 1733 (795) 667 (386) 2497 (695) 1370 (514)
5689 5378 4867 3489 4644 2978 4422 2822 4856 3717
1.76 2.62 1.33 0.61 1.92 1.23 1.90 2.10 1.95 2.31
1306 (394)
1.19 (0.249)
1933 (575)
4286 (796)
1 2 3 4 5 6 7 8 AVE1 AVE2
3446 3169 2538 2400 2615 2538 2585 2677 2888 2603
AVEALL
2746 (965)
(1518) (1193) (1363) (1140) (1487) (1466) (1261) (1170) (1049) (999)
(0.093) (0.016) (0.196) (0.545) (0.068) (0.230) (0.070) (0.047) (0.064) (0.030)
2.44 (0.023)
NPT: no public transfer; PT: public transfer; LU: low use of equity; HU: high use of equity; AVE1: mean reported income across periods 1–4; AVE2: mean reported income across periods 5–8; AVEALL: mean reported income across periods 1–8. a The standard error of the mean.
The equity effect becomes more obvious when the LU and HU groups are compared in each public transfer condition. As the taxpayers in each public transfer condition face the same economic incentives in making the reporting decision, any difference in reported income may be attributable to the different use of perceived equity. Table 3 shows that the HU group, on average, reported significantly higher income than the LU group in the PT condition, and that in the NPT condition the HU group reported lower income than the LU group, although this difference in the NPT condition becomes statistically significant only in the last period. When taxpayers consider exchange equity in their decisions, those who receive a public transfer (no public transfer) tend to comply more (less) than their counterparts in the same public transfer condition who do not consider exchange equity in their decisions. The results strongly imply that equity matters to certain taxpayers in making their reporting decisions. Some taxpayers evade more because they face inequity (that is, the HU group in the NPT condition). Yet more importantly, some taxpayers comply more because the system is equitable (that is, the HU group in the PT condition). As the responses of the subjects to whether their perceptions of fairness affected their decisions were collected after the experimental tasks, the use of fairness might simply have been a justification for tax evasion. If so, then taxpayers who rate the use of fairness higher would generally report income less. However, there was no significant correlation between the reported income and the use of fairness (p ¼ 0:857). Furthermore, the use of fairness resulted in higher compliance amongst the subjects in the PT condition of the HU group. These subjects reported significantly higher incomes than those subjects in the PT condition who did not seriously consider fairness in their decisions. We also tested whether the responses varied significantly over
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the NPT and PT conditions. The t-test results showed no difference (t ¼ 0:94, p ¼ 0:351) in the responses between the two conditions, and we can conclude that the task behavior of the subjects (which differed between conditions) did not affect their responses to the ex post questions. 4.3. Other analyses The mean number of lotteries chosen was 5.9 out of 15, which implies that subjects were generally risk averse. Furthermore, there is no significant difference in risk preferences between the NPT and PT conditions for all subjects (t ¼ 0:40, p ¼ 0:689), for the LU group (t ¼ 0:05, p ¼ 0:958), or for the HU group (t ¼ 0:65, p ¼ 0:525), which implies that any difference in mean reported income between the NPT and PT conditions for each of the LU group and the HU group cannot be attributed to systematic differences in the subjectsÕ risk preferences across the two public transfer conditions.
5. Discussion The design of this paper allows the direct examination of the role of exchange equity in tax reporting decisions by first providing an unambiguous prediction concerning the economic effect of the public transfer on reported income. In addition, the exchange equity of each taxpayer is manipulated by the provision of the public transfer, the level of which is independent of other taxpayers as well as individual reporting behavior, and the perception of exchange equity is then measured. Furthermore, the degree to which taxpayers use the perception of exchange equity in their tax reporting decisions is also measured. This paper provides additional insights into the mechanism of tax reporting behavior when the public transfer is provided. The findings reported here will contribute to the development of more adequate descriptive theory for a broader approach to tax compliance as well as future research design, especially in experimental studies. Moreover, the findings have policy implications. Policy makers may be able to reduce or prevent the negative effect on tax revenues of a particular level of taxation (due to increased evasion) by not only using economic sanctions, but also by explicitly demonstrating to taxpayers the benefits of their tax payments. These efforts may be more effective on those taxpayers whose behavior is more likely to be influenced by equity considerations, given the observation that a certain taxpayer group may be strongly affected by perceived exchange equity in their tax reporting decisions. Thus, it is beneficial for governments to understand the process by which taxpayers perceive fairness in their exchange relationships and, more importantly, to explore the characteristics of those taxpayers whose tax reporting behavior is more likely to be influenced by perceived exchange equity. There are several potential limitations regarding the generalizability of the findings in this paper. One possible limitation is the use of natural or loaded terms in the experiment. Alm (1991) claims that it is not possible to generalize beyond the lab-
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oratory unless neutral instructions are used. However, because the tax reporting decision is not necessarily a simple gamble, experiments with neutral terms may not be able to capture other factors such as tax perceptions, which appear to be important in determining reporting behavior in tax compliance research. Moreover, Fischer, Wartick, and Mark (1992) argue that the generalizability of lab experiments can be enhanced by making the setting more reflective of real-world settings. Thus, the use of natural terms may be an unavoidable limitation, especially in tax experiments. However, to minimize any loss of control due to the use of natural terms, our subjects were provided with information that was as complete and precise as possible regarding factors relevant to their tax reporting decisions. Alm et al. (1992) have shown that if complete and precise information is provided, then the use of loaded versus neutral instructions produces virtually identical results, which implies that subjects do not need to rely on their scripts to fill in missing information when sufficient relevant information is provided. A second limitation is that only eight repetitions of the experimental task were conducted. This might not have provided sufficient time for the behavior of subjects to stabilize. However, whilst increasing the number of repetitions might yield data of superior quality, it might also increase the danger that responses (including the apparent stability of responses) reflect boredom or fatigue rather than the behavior of interest (Davis & Swenson, 1988). Given the simple nature of the experimental task in this study, the cost would outweigh the benefit of increasing the number of repetitions. Moreover, for studies of comparative statistics such as this paper, the number of repetitions might not be critical unless ‘‘learning’’ affects each group differently. Furthermore, the patterns shown in Table 3 and Fig. 2 might imply that if there had been more repetitions, then the results would more likely have been stronger, especially for the LU group. Of course, we cannot rule out the possibility that the increase in income from the public transfer is not sufficient enough to induce a significant income effect, and this has potential as the basis of a future research agenda. Moreover, the task described in this paper does not represent an actual taxpayer decision problem, and only includes one income source. Whilst understating income is the only way to evade taxes in this experiment, the mis-statement of expenses is also widely used by real taxpayers as the method of tax evasion. Parameters such as audit probability and penalty were higher in the experiment than those in most actual tax settings. However, it may not be too high as, in practice, the discovery of fraud in one year often leads to the investigation of potential fraud in previous years. If Internal Revenue Services extend their investigations to the last five years (six years) of reporting, then the 20% audit rate in a one period game (as in the reporting situation of this study) is approximately equivalent to 4.4% (3.6%) per year in multi-period settings (as in real tax reporting situations). In addition, as there is no theory to predict an interaction between PT conditions and the level of audit probabilities, the ‘‘unrealistically high’’ audit rate cannot explain the experimental results. Finally, whilst the public transfer conditions are used as a between-subjects treatment in this study, using a within-subject treatment might result in more significant
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differences, as one condition can clearly be framed as a reference in terms of wealth level and perceived exchange equity. This is an open-ended question that can be addressed by future studies.
Acknowledgements I gratefully acknowledge the comments and suggestions of Henry Robben (Associate editor), two anonymous referees, Don Moser, Bill Waller and seminar participants at the HKUST. I am particularly grateful to Harry Evans III for his insightful guidance. I acknowledge the financial support of the Hong Kong University of Science and Technology.
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