58 Pages Posted: 26 Aug 2013 Last revised: 2 Jul 2014
Date Written: August 26, 2013
The lack of progress over the past decade in reducing the tax gap, particularly the failure to reduce the rate of noncompliance among the self-employed, demonstrates the need for innovative approaches. Recent increases in information reporting likely will have an impact in some areas, but the elephant in the room is the cash economy. Given the limitations of standard deterrence techniques, prospect theory has much to offer in improving tax compliance among small business owners for whom information reporting or withholding is not feasible.
A number of economists and psychologists have found that prospect theory is a relevant predictor of taxpayer behavior. In the context of framing, the theory predicts that taxpayers claiming a refund tend to view the outcome as a gain, and thus will demonstrate risk aversion, making them more likely to comply. On the other hand, taxpayers facing a balance due, generally framed as a loss, tend to be risk-seeking, making them more likely to evade. This behavior has been confirmed by numerous empirical studies involving laboratory subjects, and by studies of IRS compliance data covering hundreds of thousands of actual taxpayers.
Thus far, the legal community has made little use of this empirical evidence. To fill this gap, this Article proposes a novel approach to target small business noncompliance that relies on the demonstrated connection between tax compliance and the presence of a tax refund. I propose that tax for small business owners be collected on a presumptive basis (what I call "presumptive collection") throughout the year based on principles used in presumptive tax regimes employed by other countries, which impute income based on external factors rather than relying on self-reporting. However, unlike true presumptive taxes, presumptive collection would collect tax on a presumptive basis, but the regular income tax would ultimately apply to determine a small business owner’s final tax liability at year-end, analogous to withholding. Because individuals are more likely to comply if they find themselves facing a refund at the time of filing, the goal of presumptive collection would be to increase the number of small business owners that will face such a frame at year-end.
Although not every type of small business would be amenable to presumptive collection, it could be an important additional tool for reducing tax evasion that is targeted at specific industries. If presumptive collection could be applied to groups of identifiable cash businesses that are currently able to avoid information reporting, then policymakers could make significant gains in reducing small business tax evasion.
Keywords: Tax, Tax Policy, Tax Compliance, Tax Evasion, Prospect Theory, Framing, Cash Economy, Behavioral Economics
JEL Classification: E62, H20, H21, H23, H25, H26, H29, K34, D81, A12, K42
Suggested Citation: Suggested Citation
Thomas, Kathleen DeLaney, Presumptive Collection: A Prospect Theory Approach to Increasing Small Business Tax Compliance (August 26, 2013). 67 Tax Law Rev. 111 (2013). Available at SSRN: https://ssrn.com/abstract=2316233
By Alexander Wu