Fairness, Legitimacy and Tax Compliance

Governments are dependent on a high degree of voluntary compliance with tax laws. Therefore, there is much to be gained in understanding what things may influence taxpayers’ voluntary cooperation and willingness to comply with tax laws and what things may interfere with compliance. This line of inquiry is particularly important in situations where a taxpayer’s non-compliance may be difficult for a tax authority to detect—for example, when a taxpayer has cash earnings. The reporting of cash earnings is the example that we used in our study.

We study the degree to which certain types of perceptions of fairness about the tax authority influenced taxpayers’ willingness to comply with tax laws. Specifically, in this study, we examined whether a taxpayer’s compliance might be influenced by their previous experience of being dealt with fairly or unfairly by the tax authority. People care about fairness because it is a basic human need and are more likely to comply in the presence of fairness. We hypothesised that when a taxpayer feels that the tax authority has been fair in the past, they would be more likely to comply with tax laws. Alternatively, when a taxpayer feels that the tax authority has been unfair in the past, we expect they would be more likely to cheat on their taxes.

We also hypothesised that the influence of fairness on tax compliance would occur because of the impact fairness may have on a taxpayer’s belief in the legitimacy of the tax authority. We considered that taxpayers’ motivation to comply with tax laws relates to their beliefs about the legitimacy of the tax authority (in other words, a belief that the tax authority deserves to be obeyed). And to combine these two thoughts, we predicted that a tax authority’s fair or unfair treatment of a taxpayer would affect that taxpayer’s belief in the legitimacy of the tax authority, which would in turn influence the taxpayer’s subsequent compliance.

We investigated two kinds of fairness in this study. Procedural fairness in a tax situation is concerned with whether a fair process is used by the tax authority in determining a tax outcome, such as whether a taxpayer is treated consistently compared to another taxpayer. Distributive fairness is whether the amount of taxes paid by one taxpayer is fair relative to taxes paid by other taxpayers and reflects the ideal that outcomes ought to be distributed fairly amongst individuals.

An experimental study

Our experiment was conducted with the help of 389 taxpayers. Participants were recruited by a consumer research firm that has a database of 4 million Americans and included taxpayers between the ages of 25 and 80, evenly distributed across age groups, with a 50/50 gender split. Our sample distribution was like that found in the United States population of taxpayers.

We provided each participant with a hypothetical scenario incorporating the above elements. The protagonist in the scenario had some cash earnings and our participants were asked to predict whether he would report these cash earnings in his tax return, imagining that they, themselves, were this taxpayer. Asking about tax compliance in an indirect way (that is, having someone imagine that they were someone else) mitigates against social desirability bias. Before the participants made their tax compliance response, they had learned about some history this taxpayer had with a tax authority—specifically about the fairness (or unfairness) that he had experienced in the previous tax year.

Participants in the experiment were told that the tax authority was either fair or unfair in terms of procedures or outcome distributions. We manipulated fair versus unfair distributions by telling participants the tax outcomes were fair (unfair) compared to other known situations. We manipulated perceptions of the fairness of procedures by telling participants that the authority’s dispute resolution process was fair or unfair. One group received information that this taxpayer had experienced both procedural and distributive fairness with this tax authority. Another group received information that this taxpayer had experienced both procedural and distributive unfairness. Other participants read that this taxpayer had experienced procedural fairness and distributive unfairness and another group read that this taxpayer experienced procedural unfairness and distributive fairness.

After reading their version of this taxpayer’s history with the tax authority and then predicting whether this taxpayer would likely report his cash earnings on his current year tax return, participants were asked questions intended to measure their assessment of this taxpayer’s belief in the legitimacy of the tax authority. Our questions asked about the extent to which the tax authority does its job well and the importance of following the rules established by the tax authority. In this way we could determine the influence of previous fairness/unfairness on assessments of taxpayer compliance and analyse the role of legitimacy.

Both kinds of fairness are important

The results of our experiment showed that both distributive fairness and procedural fairness did influence the participants’ assessments that they (in their role as this taxpayer) would report the cash earnings in their tax return. We found that the two types of fairness significantly influence compliance intentions and that procedural and distributive fairness have an equal and additive effect on compliance. Our effect size is between small and medium, and the effect sizes of both distributive fairness and procedural fairness are almost identical, meaning that one type of fairness is not more important than the other.

We also found that the influence on compliance occurred through the mediation of the taxpayer’s belief in the legitimacy of the tax authority, as we expected. We found that the influences of procedural and distributive fairness on both legitimacy beliefs and on compliance were independent of each other—that is, their effect was not interactive. Thus, for one type of fairness to improve compliance, the other type does not have to be present.

By randomising the order in which information on procedural and distributive fairness was presented, we concluded that the order of obtaining information about procedural versus distributive fairness did not affect the results.

In terms of tax policy, this study highlights the importance of a tax authority being both distributively fair and procedurally fair and being seen to be fair. Our findings suggest and reinforce that tax authorities should ensure that their procedures are perceived as fair, and that taxpayers’ outcomes are consistent across taxpayers. Doing both may result in greater compliance than demonstrating only one of these forms of fairness. If a tax authority creates situations that are procedurally fair but distributively unfair, or vice versa, compliance may suffer as compared to situations that are both procedurally and distributively fair. Therefore, in addition to striving for fairness, tax authorities should also seek to communicate with taxpayers that fairness has occurred.

Finally, tax authorities should also note the importance of taxpayer perceptions of their legitimacy in terms of compliance. Compliance may be enhanced when efforts are made to improve perceptions of legitimacy. Moreover, our results suggest that a tax authority’s legitimacy in the eyes of taxpayers is important for compliance.

 

This blog is based on our paper, “Fairness, legitimacy, and tax compliance”, eJournal of Tax Research, 19(2): 186-212.