Application of behavioural economics for improving voluntary direct tax compliance in India

Abstract

India’s tax-to-GDP ratio at 16.6% has traditionally been lower than other comparable developing economies by an average of 5.4%. Out of total taxes, share of progressive taxes i.e. direct taxes has remained more or less constant at 5.5%. While some of the reasons for this sluggish tax-to-GDP ratio could be attributed to factors such as lower per capita income and tax exemptions for agriculture income, charitable trusts and educational institutions; yet the predominant cause relates to low level of compliance in vast unorganised sector, parallel economy and tax disputes and litigations. In a statistics released by the Income Tax Department for the Assessment Year 2014-15, the total no. of e-filed returns was 3.91 crores which is an abysmally low compared to the total workforce of India. Strategies for improving voluntary compliance by taxpayers have largely been service oriented centring around IT enabled solutions like e-filing of returns and payment of taxes, increase reliance on e-governance initiatives and quick e-redressal mechanisms. The traditional approach of enforcement definitely continues in the form of scrutiny assessments (audits), searches and surveys, monitoring of non-filers and stop filers, etc and the department is strengthening its enforcement machinery by building its own intelligence and collating the data as well. However, increased efforts on enforcement mechanisms come with their share of costs and externalities. First, higher frequency of searches and audit surveys increase the costs of tax administration significantly, and corresponding returns from intrusive action tend to flatten out. Secondly, excessive intrusive actions create a sense of anti-business climate in the economy, thereby adversely affecting the morale of potential investors and ease of doing business. Traditional approach towards the problem of compliance assumes taxpayers to be rational actors who make the decision whether to comply with their tax obligations, by comparing the expected cost of compliance i.e. the tax, with the expected cost of evasion. The expected cost of evasion depends on the statutory penalty if the evasion is detected and the probability of its detection. The model thus dictates that the compliance can be increased by making the cost of evasion higher by increasing the probability of detection or increasing the penalty for evasion, or some combination of the two. 4 However, behavioural economics seeks to break from the traditional idea that a single theory of human behaviour can be both normative and descriptive. It set to offer an alternative to expected utility theory that has no pretence of being a useful guide to rational choice. Instead, it attempts to predict the actual choices real people make. Studies conducted around behavioural economics in general, and Prospect theory in particular, in the area of tax compliance indicate that taxpayers who are going to claim refund are more compliant while taxpayers whose tax payments are due are likely to have aggressive non-compliant behaviour. Various studies have suggested that policies should be centred around pre-payment of taxes in order to improve compliance. Experiences in India suggest that introduction of provision of advance tax, TDS and presumptive taxation have definitely improved compliance but somewhere the growth of compliance has stagnated. Two key reasons are attributed to this are large portion of unorganised economy which largely escapes the pre-payment provisions and a small enforcement machinery to execute the law and act as an effective deterrence. The policy memo recommends employing principles of behavioural economics, in improving the voluntary compliance among tax payers at much reduced administrative costs. The main theme of behavioural approach to tax compliance is that individuals are not simply independent selfish utility maximisers but that they also interact with other human beings in ways which depend on different attitudes, beliefs, norms and rules. Contributions from disciplines such as sociology and psychology suggest that there are range of other factors that might influence taxpayers’ behaviour such as social support, social influence, attitudes towards the State and revenue authorities and perceptions of equity. The area of behavioural economics in tax compliance has been a less explored area. Though the income tax department has floated many campaigns around nudging people through posters, TV advertisements and social media, no the efforts have centred around linking taxes with one specific outcome/activity. There are international experiences, like the efforts of BIT, which indicate that when the application of taxes are directly linked to some specific cause, the compliance rate has improved. In India, the efforts have been general and not specific to any such outcome/activity. The policy question, hence, remains if tax payment is directed towards a specific outcome/activity, will it improve tax compliance? A policy is suggested around specific question and will propose a roadmap for implementation of the policy.