Erich Kirchler University of Vienna, Austria TARC Master Class London - 2014

1. Tax Psychology (3) Decisions under uncertainty (risk) Erich Kirchler University of Vienna, Austria TARC Master Class London - 2014

2. Economics Ideas of humankind: Homo Oeconomicus Utility maximization Rationality (consistent, goal-oriented behaviour) 2 2 2 2 2 2

3. Economics Utility maximization Rationality assumptions: Axioms Completeness (a > b; b = c; c > d; ...) Transitivity (if a > b and b > c, then a > c) Reflexivity (a = a) Non-satiation (a + 1 > a) Continuity (a, b) = (a – x, b + y) Convexity (Law of Saturation) 3 3 3 3 3

4. Payingtaxesasoutcome of a decisionunderrisk

5. Tax rate Income Audit probability Fines Tax compliance 1 Net income No audit Net income + evaded amount 1 - p Tax evasion p Net income - fine Audit Howtoincreaseandguaranteetaxcompliance ? Decisionunderrisk Allingham & Sandmo (1972); Srinivasan (1973) Becker, G. S. (1968). Crime and punishment: An economic approach. Journal of Political Economy, 76, 169-217. Sureoption Riskyoption

6. Audit Fine rate probability 1 2 4 ----------------------------------------------------------------------------- 0.05 9.0 ( 4.0) 6.9 ( 3.2) 12.2 ( 4.2) 0.30 10.9 ( 6.0) 21.4 ( 4.4) 39.8 ( 7.4) 0.60 9.8 ( 8.0) 54.8 (10.6) 70.3 ( 7.5) Average compliance rate by fine rate and audit probability (standard deviations in parentheses; Alm et al., 1995, p. 11)

7. Whatdoesthetheorysayaboutwhatmotivatestaxcompliance ? • The standardtheory of human behaviourisbased on severalassumptions: • Individualsare rational, • Individualshaveunlimitedwillpower, • Individualsareself-interested. • From James Alm, 2014, Tulane University, USA.

8. Whatdoesthetheorysayaboutwhatmotivatestaxcompliance ? • The startingpoint: Economics-of-crimemodel • A rational individual weightstheexpectedbenefits of successfulcheatingagainsttheriskyprospect of detection and punishment. • The individual paystaxesbecause he orsheisafraid of gettingcaught and penalized. • Indeed, the individual paystaxesbecause – and onlybecause – of thefear of detection and punishment. • Compliance depends upon enforcement. • From James Alm, 2014, Tulane University, USA.

9. Whatdoesthetheorysayaboutwhatmotivatestaxcompliance ? • However, … • Individualsfacelimits of theirabilitytocompute (e.g., boundedrationality) • Theysystematicallymisperceive, or do not perceiveat all, thetruecost of theiractions (e.g., fiscalillusion, saliency, overweightingof (low) probabilities) • Theyfacelimits of theirself-control (e.g., hyperboicdiscounting; Christmas clubsavings) • Theyareaffectedbytheways in whichchoicesareframed (e.g., referencepoints, gains versus losses, lossaversion, risk-seeingbehavior) • Theyareaffectedbythesocialcontext in which, and theprocessbywhich, decisionsaremade • Theyaremotivatedbynotions of fairness, altruism, trust, guilt, shame, morality, alienation, emotions, patriotism, socialcustoms, socialnorms, taxmorale, … • From James Alm, 2014, Tulane University, USA.

10. Whatdoesthetheorysayaboutwhatmotivatestaxcompliance ? • Behavioraleconomicssuggestsseveralmainconclusionsaboutwhatmotivatestaxcompliance: • Enforcementmatters – but manyotherfactors matter in thetaxcompliancedecisionbeyondenforcement. • An individual does not alwaysbehaveasassumed in thestandardeconomicappraoch. • Individualsaresocialcreatures and areinfluencedbygroupconsiderations. • From James Alm, 2014, Tulane University, USA. Dan ArieliCheating 16 min

11. Metaanalyses Andreoni, J., Erard, B., & Feinstein, J. S. (1998). Tax compliance. Journal of Economic Literature, 36(2), 818-860. Kirchler, E., Muehlbacher, S., Kastlunger, B. & Wahl, I. (2010). Why pay taxes? A review of tax compliance decisions. In J. Alm, J. Martinez-Vazques & B. Torgler (eds.). Developing Alternative Frameworks for Explaining Tax Compliance (pp. 15-31). London: Routledge. Most people are honest !

12. Correlations between tax evasion and measures of psychological instigations and constraints (Elffers et al., 1987) Dissatisfaction Dissatisfactionwith tax authorities Comprehensibility of rules Personality Competitiveness Alienation Tolerance of deviance Fear of punishment Socialcontrol Personal control (attitudes) + + 0 + + 0 - 0 0 + 0 0 - 0 0

13. Enforcingtaxcompliance • Deterrence • To protect honest taxpayers from free riders, controls are necessary. • Negative sanctions are necessary at an adequate level and in the proper form, depending on the ability of the tax offender to pay. • Tax authorities need to cooperate intensively with legislators, judges, and international authorities. The effectofdeterrencemeasuresisweakandsometimesoppostitetotheintendedeffect…

14. Enforcingtaxcompliance Whateffecthavefines ? Whateffecthaverepeatedaudits ?

15. A fineis a price ! Gneezy, U. & Rustichini, A. (2000). A fineis a price. Journal of Legal Studies 29(1) 1-18. Experimental group: Managements of 6 daycarecentersintroduced a fineforlate pick up of children; Controlgroup: 4 daycarecentersdid not introduce a fine.

16. Reducing undesirable behavior by special taxes Australia’s National Tobacco Campaign Shift from a weight to a stick based system Extra tax on tobacco products Harmonization of fees in different states (to end cross-border Evasion of cigarette taxes) % of smokers classified as heavy smokers (25+) Scollo, Younie, Wakefield, Freeman, & Icasiano, 2003

17. Potential side effects of special taxes 1 Australia’s National Tobacco Campaign % of smokers using Roll Your Own Tobacco Shift towards unhealthy form of tobacco consumption Scollo, Younie, Wakefield, Freeman, & Icasiano, 2003

18. Potential side effects of special taxes 2 Cigarette sales & consumption in Washington State (USA) Taxrisefrom 25c to 75c per pack Consumption remains stable  Presumably due to smuggling Stehr, 2005

19. Tax compliance(Kirchler, Maciejovsky & Schwarzenberger, 2005) .6 .5 .4 .3 .2 .1 0 Compliance 0 1 2 3 4 Base-linePeriodsfollowingaudit Misperceivedprobability & Loss repair Audit probability 30 % 20

20. Robust phenomena: the “bomb cratereffect“ and the „echo effect“ (Guala & Mittone, 2005; Mittone 2006; Kastlunger et al. 2009; Maciejovsky et al. 2007)

22. Tax due Average tax paid Audit 1 7 13 19 25 31 37 43 49 55 4 10 16 22 28 34 40 46 52 58 “Echo” effect in experiments with audits in the first and second half of 60 business periods, respectively Guala and Mittone (2002, p. 12 and 13) Tax payments (averages, first group) Value (Italian Liras) 500 400 300 200 100 0 Round

23. Tax payments (averages, first group) Value (Italian Liras) 500 400 300 200 Tax due Average tax paid 100 Audit 1 7 13 19 25 31 37 43 49 55 4 10 16 22 28 34 40 46 52 58 0 Round “Echo” effect in experiments with audits in the first and second half of 60 business periods, respectively Guala and Mittone (2002, p. 12 and 13)

24. Impact of immediate versus delayedaudits on taxcompliance and perceivedfairness of authoritiesKogler, C., Mittone, L. & Kirchler, E. (2014) Timing of feedback of taxauditsmatters • Uncertaintyresolution in taxexperiments: waiting for an auditincreasestaxcompliance(Muehlbacher et al., 2012) • Problem: auditsdirectly after filingtaxes in most taxexperiments, but in reality oftenyears after filing a taxreport (e.g., Austria 5-10 years) Feedback related to trust, trustrelatedtocompliance • In othercontexts (e.g., organizationalpsychology; Sapienza & Korsgaard, 1996) timeliness of feedback was identified to increasetrust and acceptance of decisions • In taxliteraturetrust in state/authorities was identified as an important determinant of taxcompliance and taxmorale (e.g., Torgler & Schneider, 2004; Braithwaite & Wenzel, 2007; Kirchler et al., 2008)

25. Experimental Design • 22 rounds of taxpaying in a laboratoryexperiment • Regular income • 3000 ECU, tax rate: 900 ECU • Pay-off determined at the end (oneroundrandomlychosen) • Audit probability: 15% • Rounds 3, 12, 21 for all participants to keep effects of auditsconstant • Fine in case of detection • 2 x evadedamount (paying back + fineequal to evadedamount) • Feedback • After eachround vs. onlyatthe end (summary after the last round) • Rounds of reducedearnings • Rounds of reducedearnings: R8-10, R17-18 • Reducedincome of 2500 ECU vs. additional tax of 500 ECU (compulsory) • Questionnaire: • Items: perceivedfairness of taxauthorities, voluntarycompliance, subjectiveauditprobability, perceivedseverity of fine, perceivedfairness of timing of feedback, generaltaxmorale, socio-demographicdata, etc.

26. Results I – Feedback x CompulsoryTax Covariate Gender: Meanfemales = 69.49% Meanmales = 50.60% F(1, 121) = 7.44, p < .01 Audit Mean immediate feedback = 50.75%, Meandelatedfeedback = 69.29% F (1, 122) = 11.30, p < .01 ReducedEarnings

27. Immediate vsdelayedaudits In experiments, uncertainty if tax report is audited is resolved immediately, whereas in real life it can take up to 7 years to know if your audited or not (Zeigarnik-Effect; unfinished businesses) Compliance decision (pay 0-6 € tax) Control group Experimental group 5 minutes 3 weeks Compliance Rates: 28% 59% Muehlbacher, Mittone, Kastlunger, & Kirchler, 2012

28. Thereismorethanauditsandfines, … situational and personal characteristics; socialnorms, fairness, … andperhapstheperceptionoftaxpayersascheatersisshort-sighted.

29. Diffusion ofincometaxevasion 10-15% of underreported income Porcano(1988), the U.S. IRS estimated 10-15% of underreported income in 1983. Five years later the tax gap was about 17% of true liability. Andreoniand colleagues (1998) estimate that over 25% of all U.S. taxpayers underpaid their taxes in 1988. In developed countries, tax evasion is estimated to reach 20% of the level of tax revenues, while in developing countries the percentages are even higher (Orviska & Hudson, 2002). Slemrodet al. (2001) explain that the detected rate of non-compliance is 7.3%, but varies widely across types of gross income and deductions. In 1988, voluntary reporting was 99.5% for wages and salaries, but only 41.4% for self-employed income. In 2002, King & Sheffrin report that according to the U.S. IRS, 99% of wage income is correctly reported, but less than 70% of income from unincorporated businesses is correctly reported. There is little doubt that non-compliance should be contained and evasion, in particular, needs to be combated. It is, however, wrong to assume that the majority of people try to evade or avoid paying taxes. Long and Swingen (1991) write that some taxpayers are not predisposed to evade and do not search for ways to cheat. Survey studies and experiments on income tax behaviour show that honesty characterises a majority of participants (e.g., V. Braithwaite, 2003d; James & Alley, 2002; Kirchler, Muehlbacher, Hoelzl, & Webley, 2005). Antonides and Robben found that 4.2% of participants in their study corrected their tax files to their disadvantage, whereas 23.8% corrected them to their advantage (Antonides & Robben, 1995). Assuming that those negatively correcting their files made unintentional mistakes, and an equal percentage of those who positively corrected their files did so also undeliberately, then less than 20% were intending to cheat. On the basis of 1982 U.S. IRS audit data, Alexander and Feinstein (1987) report that approximately one quarter of all taxpayers make accurate tax reports. According to their analysis, 13.5% overstate their taxes, presumably due to errors in completing tax returns. If the same percentage understates their taxes due to errors, then more than half of taxpayers tend to be honest. Hessing, Elffers, and Weigel (1988) estimate that more than two thirds of taxpayers declare their income honestly. The assumption that taxpayers are generally compliant is challenged by the wide use of tax preparers and studies contending that taxpayers generally demand aggressive advice (Duncan, LaRue, & Reckers, 1989; Jackson, Milliron, & Toy, 1988; Milliron, 1988). These studies were conducted from tax preparers’ view, but investigations from taxpayers’ perspectives reveal a different picture. The use of a tax practitioner does not seem primarily driven by the desire to avoid paying taxes, but by the uncertainty about the tax law and the motivation to report correctly. 25% underpaid 7.3% non-compliance, wide variation across types of income and deductions Elffers (2000) writes, “[…] the gloomy picture of massive tax evasion is a phantom”. voluntary reporting 99.5% for wages and salaries, but only 41.4% for self-employed 4.2% corrected their tax files to their disadvantage, 23.8% corrected them to their advantage. Assuming that those negatively correcting their files made unintentional mistakes, and an equal percentage of those who positively corrected their files did so also undeliberately, then less than 20% intend to cheat. ¼ make accurate reports. 13.5% overstate their taxes, presumably due to errors. If the same percentage understates their taxes due to errors, then more than half of taxpayers tend to be honest. 2/3 declare their income honestly The use of a tax practitioner does not seem primarily driven by the desire to avoid paying taxes, but by the uncertainty about the tax law and the motivation to report correctly.

30. Economic Psychology Agenda • Self-Conception Ideas of Mankind • Objectivity & Intentions Methods • (Psycho-) Logics Economic Decisions • Rituals of Adults Lay Economic Theories • The Invisible Hand Markets • Mental Accounting Consumption, Saving, Loans • Trick & Treat Marketing Policy • Courage & Risk Businessmen/women • 20 US Cents Work & Satisfaction • Invulnerability Financial Markets • Whatever you want! Currency & Inflation • In the Shadow Counter-Productivity • Nudges State: Power and Trust • 75.000 US$ Prosperity and Happiness 31

31. Cognitive scrooges: Reality is subjectively construed and interpreted Estimation of the diameter of coins Optical illusions Decision Anomalies: Perception of information 32 32 32 32 32 32

32. Paying back loans Youhavelended 3.000 € and needtopayit back with 12% annualinterest rate. Eachmonthyoupay 30 €. Howlongdoesittaketopaythecredit back? lessthan 5 years 5 to 10 years 11 to 15 years 16 to 20 years forever 15% 31% 18% 10% 26%

33. Emotions Probabilities are ignored or low probabilities are overestimated The willingness to pay to avoid electric shocks barely depends on the probability of being exposed to electric shocks (Rottenstreich & Hsee: Money, Kisses, and Electric Shock: On the Affective Psychology Risk. Psychological Science, 2001) Money 18 16 Prices paid to avoid electric shock and $20 penalty 14 12 Shock 10 8 6 4 2 0 99 % 1 % Probability Risk and emotions 34 34 34 34 34

34. Risk-aversion Daniel Bernoulli (18th century): Human beings are risk averse! A sure gain of € 8.000 is preferred to a possible gain (p = .85) of € 10.000. 35 35 35 35 35

35. Risk-aversion and -inclination Sure win of € 240 or25 % chance of winning € 1.000 and 75 % chance of winning 0 Sure loss of € 750 or75 % chance of loosing € 1.000 &25 % chance of loosing 0 36 36 36 36 36

36. Prospect Theory Descriptive decision theory explaining a number of decision anomalies in decision making under risk. Phase 1: Editing Simplification of the decision problem Phase 2: Evaluation Assessment of the alternatives 37 37 37 37 37

37. Prospect Theory Phase 1: Editing Simplification of the decision problem Coding: What is an event related to (reference point)? Combination: Independent events are often seen combined. Segregation: Safe events are often separated from risky ones. Cancellation: Identical aspects of two alternatives are ignored whereas disparities are weighted heavily in judgments. 38 38 38 38 38

38. Prospect Theory Phase 1: Editing Simplification of the decision problem Simplification: e.g. odd numbers are rounded. In the case of very low or very high probabilities this process is fundamental. Detection of dominance: Salient alternatives are discarded in the beginning and are not taken into account any further. 39 39 39 39 39

39. Prospect Theory • Phase 2: Evaluation • Assessment of alternatives • Assessment is guided by two principles • The value is estimated in relation to a reference point. • Probabilities are taken into account. 40 40 40 40 40

40. Prospect-Theorie Subjectivevalue + concave Reference point Gain Loss -A -B A B - convex

41. Prospect Theory: Weighting function 1 Decision weight 0.5 0 0 0.5 1 42 42 Probability p

42. Neuropsychology / Neuroeconomics Support for the assumptions of the prospect theory comes from neuroeconomics, examining the brain activity while decisions are made. Neuroscientific methods allow the analysis of the activities of the human brain (e.g. Prince & Pawelzik, 2008). In addition to imaging and psychophysiological methods, the measurement of individual neurons, the electrical brain stimulation or the elimination of brain regions can be counted among the methodological tools of neuroscience and, more recently, of neuroeconomics. First and foremost imaging and psychophysiological methods are used. Apart from the electroencephalogram (EEG), positron emission tomography (PET) is used, which allows the creation of cross-sectional images of the brains of humans and mapping biochemical and physiological processes. Currently, functional magnetic resonance imaging (fMRI) is most popular. This method allows the representation of metabolic activity in the brain by measuring the magnetic properties of oxygenated and deoxygenated blood. Using psychophysiological methods, different physiological responses to a stimulus, such as blood pressure, heart rate, sweating, dilated pupils or muscle tone, can be measured (Sanfey, 2007). Many studies have shown that economic decisions are correlated with neurophysiological processes (e.g., Delgado, Locke, Stenger, & Fiez, 2003; Knutson, Taylor, Kaufman, Peterson, & Glover, 2005). Sanfey, Rilling, Aronson, Nystrom, and Cohen (2003) examined fMRI responses of the players to fair and unfair offers in the ultimatum game and found out that in the case of rejected, unfair offers other brain regions are activated, as in the case of accepted, unfair offers. 43 43

43. Experiment 25 5 1. Choose 5 or 25 2. Outcome: gainorloss 3. Result: 25 gain & correct 5 gain & incorrect 25 loss & incorrect 5 loss & correct 265 milliseconds after the information about a win or loss => higher amplitude of a potential springing from the frontal area of the Cerebrum Medium in the event of a loss. 4. Brain activity:

44. Libertarian Paternalism Asymmetric (libertarian) paternalism: Does not affect rational decision makers; Works to the advantage of biased decision makers. Policy applications Providing information; Framing; Changing status quo; Format effects; Motivational effects.

45. Tax compliance of people who are liable to wage tax and of self-employed persons as a function of the refund amount or balance due(Cox & Plumley, 1988; as cited in Webley et al., 1991) Compliance rate in percent 100 wages/salaries 95 90 business income 85 80 75 70 65 <-1.000 <- 500 <- 100 <- 0 >- 0 >- 100 >- 500 >-1.000 balance due refund Size of refundorbalance due (US $)