Tax Compliance

Tax Compliance Example

Let's go over an example of tax compliance. We will look at an example of both the individual and business decision to comply with taxes.

Individual Tax Compliance

Individual tax compliance revolves around reporting accurate yearly income. In the United States, individuals file their taxes and are required to file them appropriately, given how much income they earn. If individuals fail to report all of their income to avoid paying taxes, then this would be tax evasion.² While individuals are responsible for filing their taxes accurately, they can also pay for a service to assist them in this process; after all, the penalty for not complying is quite large!

Business Tax Compliance

Business tax compliance is similar to individual tax compliance in that it revolves around reporting accurate yearly income. As you can imagine, keeping track of income at the business level is no easy task! Businesses will need to pay the proper state and federal taxes; businesses will have to keep track of any charitable donations they made; businesses need to have an employee identification number; etc.³ Failing to comply with tax laws can result in serious consequences for businesses. Therefore, businesses will usually have a tax accounting service to assist them with tax compliance.

Importance of Tax Compliance

What is the importance of tax compliance? The importance of tax compliance is that by paying their taxes, individuals and businesses are funding the government's tax revenue. Government tax revenue is important for a variety of reasons, from balancing the budget to providing goods and services to its citizens. Without a consistent stream of tax revenue, the government would not be able to accomplish these goals. Let's take a deeper look at how tax revenue is used to balance the budget and pay for goods and services.

Balanced Budget

For a government to properly balance its budget, it will need to account for its revenue and spending. Let's look at the equation for the budget balance for further clarification:

\(\hbox{Savings}=\hbox{Tax Revenue}-\hbox{Government Spending}\)

What does the equation above tell us? In order for the government to balance its budget, it needs to offset any high government spending with increased tax revenues. One way the government can do this is to simply increase the tax rate for all citizens and businesses. By enforcing tax compliance, the government can increase the tax rate and increase its tax revenue to balance its budget. However, what if individuals and businesses choose not to pay taxes?

If this occurred, the government would not be able to balance its budget. Prolonged deficits can be problematic and even result in a country defaulting on its debt. It is for this reason that tax compliance is important when it comes to balancing the budget.

Let's now take a look at the importance of tax compliance regarding goods and services.

Goods and Services

The government provides us with a multitude of goods and services. How exactly does it do that? Through what mechanisms can the government provide us with so many goods and services? The answer: tax revenue! But what is the relationship between tax revenue and goods and services?

In order for the government to provide goods and services, they need to make purchases and transfers. Government purchases include increased spending on defense and infrastructure, whereas government transfers include services like Medicare and Social Security. Of course, we know that the government can't just make money out of thin air! Therefore, the government needs its source of revenue to provide goods and services to its citizens.

In order for the government to obtain tax revenue, its citizens need to comply with the tax laws. If they do not, then tax revenue will be limited in the country. Without tax revenue, the government would have a difficult time providing important goods and services. Medicare and Social Security may cease to exist, city infrastructure may be dilapidated or unsafe, and a host of other issues. Tax revenue is an important part of the process, and in turn, tax compliance becomes just as important as well.

Tax Compliance Theories

Let's discuss tax compliance theories. First, let's explain what a theory is. A theory is a set of guiding principles that are used to explain a phenomenon. In regard to tax compliance, utility theory, developed by Allingham and Sandmo, aims to see how taxpayers behave when it comes to tax compliance and tax evasion. Generally, taxpayers want to maximize their utility when it comes to reporting their taxes.⁴ If the gains of tax evasion outweigh the costs, then taxpayers are more likely to evade their taxes and not comply with the tax laws.

Another aspect of theories is the components that make up the theory in the first place. For example, James Alm believes that there are key elements that are included in most tax compliance theories. Those elements include detection and punishment, overweighting of low probability, the burden of taxation, government services, and social norms.⁵ Let's take a deeper look at the social norm element.

Social norms can have a major impact on whether people comply with tax laws. If people typically see tax evaders as immoral, then most people are likely to comply with the tax laws. Additionally, if someone were to have friends who are tax evaders, then they are likely to evade their taxes as well. If people perceive that the tax law is unfair, compliance is likely to decrease as a result. It's important to mention that this is just one element of the five listed above! A lot goes into developing a theory of tax compliance, and there are many moving parts to explain this human behavior.

Fig. 2 - Laffer Curve.

The diagram above is known as the Laffer curve. The Laffer curve shows the relationship between the tax rate and tax revenue. We can see that a tax rate on both extremes is ineffective at raising revenue. In addition, the Laffer curve tells us that cutting taxes may prove to be more effective in generating tax revenue than raising taxes. The implication here is that lowering tax rates won't just minimize tax evasion, but also increase tax revenue as well!

Challenges of Tax Compliance

What are some challenges of tax compliance? Unfortunately, there are many challenges that come with enforcing tax laws since there are so many moving parts. The most common challenges with tax compliance are the perceptions of government spending, the legitimacy of institutions, and the extent of the penalty.⁶

Perceptions of Government Spending

How people perceive the government's spending can have an impact on tax compliance.

In contrast, if citizens did not like how the government was spending its money, then they would be less likely to comply. Therefore, a government needs to make sure it's spending its tax revenue wisely.

Legitimacy of Institutions

The legitimacy of institutions is another challenge in enforcing tax compliance. Depending on how citizens view the institution of the government can alter whether they comply with the tax laws.

Therefore, a country needs to have institutions that the public perceives as legitimate. In doing so, it can increase the chances that people comply with the tax laws.

The Extent of the Penalty

The extent of the penalty is another challenge in enforcing tax compliance. If citizens know that the penalty for evading their taxes is superfluous, then they are more likely to evade their taxes when it comes to reporting them. However, if citizens know that the penalty for evading taxes is extreme, such as jail time or a large fine, then they will be more likely to comply with the tax laws that are in place. This has some crossover with the legitimacy of institutions as well.