Nudge Economics and Tax Compliance

June 30, 2015 - It would seem the latest bright shiny ball in the policy world is Nudge Economics. On the one hand, I suppose it is good that governments are finally getting around to reading some economics books. On the other hand, governments don’t seem to read the books too carefully since they can’t seem to understand the difference between Nudge economics and, well, economics.

If you take Ec101 you will learn something about the rationality assumption. This assumption means that people make decisions that make them happy. Those decisions may appear to be weird, nonsensical, and ‘irrational’ to some observers, but in economics (well Ec101 that is) we have this condition that one should not judge the preferences underlying someone’s decision. That fact that Mike Moffat hops on one leg throwing erasers at his students to teach this concept does not mean he is irrational. It means he is rational because doing so makes him happy (his students learn the concept).

But wait, you say. People often do things that are irrational and that makes economics bunk. Well, you might want to first read this, but you might also want to take a course beyond Ec101. Sometimes we make mistakes in making decisions because we don’t have the right information, we misunderstand something like information or risks, we don’t pay attention, the costs and benefits of the choice are too closely matched, herd mentality, and so on. So we want to make decision A, but for whatever reason we make decision B.

A good example is organ donation. Almost everyone says they want to donate their organs when they die, but very few of these people actually register to be an organ donor. To become a registered organ donor you have to incur the cost of registration and simple inertia fails to make that happen. So the rational decision is to register, but we observe the irrational decision instead.

This is where Nudge comes in. Nudge is about a cost-effective ways to ensure voluntary compliance usually through a change to the choice architecture to ensure the rational decision is made. So instead of having to register to become an organ donor, we change the choice to having to register to not become an organ donor. That is, moving from an opt-in to an opt-out system is simple Nudge economics. Similar techniques have been used for retirement savings.

This is not the same as incentives. Incentives are used to change a rational choice. So a pigouvian tax, like a carbon tax is pure economics based on rationality. What I find in going to these sessions where government is talking about Nudge economics is that they do not understand the difference between Nudge economics and economics. While they talk Nudge, the actions, suggestions, phrasing are all about pure and simple incentives.

One of the areas where governments want to apply Nudge economics is to tax compliance. After all, Nudge is all about cost-effective voluntary compliance, which is pretty much how we administer our tax system. To do so, we have to understand that Nudge will not work on people who are typical tax evaders. It will not work on those for whom the tax evasion decision is a rational decision. These are people who have strong negative attitudes about paying taxes, have low risk aversion, do not care about getting caught, understand the consequences, and have a strong social norm towards tax evasion. For these people, we have incentives. Nudge will work on people who made a mistake, don’t understand the rule, lack information, follow the herd, misunderstand the risks, and so on.

There have been a number of tests of Nudge theory on tax compliance. Prepopulated forms, which opts someone into filing their taxes, increased the number of people filing their taxes. The reason is simple, the application process for taxes is a significant compliance factor for many non-filers. The down side is this UK report shows there is little evidence that pre-populated forms decrease tax non-compliance by those already filing. By sending the pre-populated form, the revenue authority shows its hand to the taxpayer. There is little incentive for a taxpayer to disclose additional income that the tax authority is not aware of.

The UK used tax letters that stated the majority of individuals pay their taxes on time, which resulted in a 15% increase in on time filings. However, when Switzerland, Minnesota, and France used the same method, they found no effect on compliance behavior. This tells us that, as always, we have to be careful about generalizing findings obtained from methodologies that don’t allow for generalizations (causality 101).

There was also interesting work that examined whether telling taxpayers where their money went helped with tax compliance. It did not. Instead, it made it worse. What did help compliance a lot (16%) was to let the taxpayer allocate some of their tax payment to a particular program.

The difficulty though with some of these Nudge interventions is that you do risk future non-compliance if these interventions are targeted to the wrong people or if taxpayers feel they are not treated respectfully. Meaning that all the Nudge work on compliance can be undone by one wrong move by CRA (its communication with taxpayers is historically dreadful) or messages coming politicians (like those in Ottawa that are already suggesting that tax is a dirty word).

So what are things CRA could do to increase tax compliance?

I’ve talked about tax lotteries before, which is an excellent example of Nudge Economics and tax compliance. And is a great idea for CRA to consider in those pesky cash industries like the renovation industry.

But the simplest of all Nudge techniques in the field of tax compliance is third party reporting. Yup, that can work as a Nudge. Consider tip income. By simply subjecting it to third-party reporting, which is already required for controlled tips, you change the choice architecture related to tip reporting. Another area is rental income, where CRA can use tenants to report their rental income paid and match it to the landlords receipts.

I would like to see CRA more active in this area, but I also it hope it takes the time to understand what Nudge is (and what it is not), who to target, and what will work in Canada. There are more than a few academics who would be thrilled to be involved in such initiatives, in exchange for publications of course.

Authored by Dr. Lindsay Tedds. Originally published on Dr. Tedds blog: Dead for Tax Reasons and republished here with permission from the author.

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