Joint Commissioner of Income Tax,
Special Range 7 , Bengaluru
Smarak Swain graduated in Electrical Engineering from Indian Institute of Technology, Kharagpur in 2006, and joined the Indian Revenue Service (IRS) in 2008. He has also done Masters in Taxation and Business Laws (MTBL) from NALSAR University, Hyderabad.
He is author of the bestselling books, Loophole Games: A Treatise on Tax Avoidance Strategies, followed by (among others) departmental officers working in investigation and corporate assessment roles, and Tangible Guide to Intangibles: Identification, Valuation, Taxation & Transfer Pricing, followed by Transfer Pricing Officers across the country.
Significant academic research has been conducted to establish factors that lead to voluntary tax compliance. A plain and pessimistic conclusion of some redoubtable research is that taxpayers have an inherent selfish motive to evade taxes; hence they have to be forced by deterrence and procedure to pay tax. But most works of research have demonstrated that taxpayers comply due to a mixture of power and trust. Power is of two kinds – coercive power and legitimate power.
This essay concentrates on the other factor that affects taxpayer behaviour: trust. Trust is critical for voluntary and cheap compliance. A simple illustration is a business that does not involve trust. If there is no trust between two parties, they have to hire advocates to draw lengthy contract. This increases the cost of doing business for both the parties. Whereas, if there was trust, they can save the money spent on advocates and advisors.
Every time there is trust, society benefits.Breach of trust leads towasteful expenses. Trust between the government and citizens makes tax compliance smooth and effortless. But how does trust lead to tax compliance? And what are the challenges in developing trust between public and public institutions like the I-T department?
The public goods game
The public goods game is a basic game in experimental economics1. In this game, all members of public are asked to contribute money to a public pot in the morning. The money collected in the pot gets multiplied n times by evening. Then the money is distributed equally among the public. Say 10 people participate in the game. Each contributes Rs. 10/- to the public pot. So the sum total in the pot is Rs. 100/-. It gets multiplied by 5 times by evening and becomes Rs. 500/-.
Each of the participants gets Rs. 50/- in the evening.
The game is continued daily. The participants do the same thing daily. Each contributes Rs. 10/- in the morning and gets Rs. 50/- in the evening. This state can be called Equilibrium 1.
One fine day, one of the participants (let us call them Evader E) decides not to contribute to the public pot. He keeps his Rs. 10/- in his pocket. The money collected in the pot in the morning is Rs. 90/- only (Rs. 10/- times 9 participants). By evening it becomes Rs. 450/-. Each participant gets Rs. 45/-in the evening. But E now has Rs. 55/-.
Others end up getting Rs. 45/- instead of Rs. 50/-. E ends up getting Rs. 55/-. What happens the next day? None of the participants puts money into the pot. None gets any money from the pot in the evening. This is Equilibrium 2.
In this game, there are only two equilibriums. Equilibrium 1 is a state in which participants trust other participants. Everyone benefits. Equilibrium 2 is a state in which there is no trust. Everyone loses out on the produce from public trust. It is, in effect, a variant of the prisoners’ dilemma. There is no other equilibrium. It is easier to move from Equilibrium 1 to Equilibrium 2; but difficult to move back from the second to first equilibrium (i.e. it is difficult to regain trust in the game).
This game tells us how citizens rationalise evasive behaviour. High Networth Individuals (HNIs) and business managers allege that the government does not properly utilise tax collected in welfare and public amenities. They perceive a high degree of corruption in application of their tax money to public good. This helps them rationalise tax evasion. The salaried class feels that HNIs and corporates have many avenues of evading taxes, but they don’t. They see episodes of tax evasion and feel a sense of relative deprivation. They rue that tax is deducted from their salary as TDS. Whenever given a chance, salaried individuals are eager to dodge tax. They tend to evade tax on capital gains (from sale of property), house rent, and miscellaneous income.
The problem here is two-pronged:
a. Develop trust between taxpayers and tax department, and
b. Develop trust among taxpayers about compliance of HNIs and corporates
A proper quantitative study has not been conducted in India yet to gauge the trust that taxpayers have on the taxation system in India. Results of a survey conducted by the Azim Premji University and Lokniti are indicative of the trust reposed by citizens on various government institutions:
It is risky to draw any conclusion on trust in tax systems from above study. Not all citizens are taxpayers. Different class of taxpayers have different level of trust on the taxation system. Further, the study does not throw light on public trust on central government institutions. But above study does indicate a general lack of trust in government institutions and government officials.
Notwithstanding indicative data on trust levels of taxpayers, how do we design a system to develop the two kinds of trust mentioned above? Prof. Dan Ariely, a professor of psychology and behavioural economics at Duke University, hints at a possible solution2. He reasons that trust between two parties can be improved by bringing in a third party whom both trust. He gives the example of individuals subscribing to an insurance company. Generally, distrust between individuals and insurance company leads to the following situation:
This process becomes a vicious self-reinforcing system that lacks trust. Expenses of the insurance company increase due to higher investigation expenses. Customers also suffer due to delay in reimbursement and longer litigation.
Prof. Ariely analysed an insurance company that brought in a third party into the equation. This insurance company said that after paying all damage claims, and after accounting for its expenses, it will give whatever is left to a reputed charity. Few days after this offer was made by the insurance company, it got call from a customer who had lost his laptop and had been reimbursed. The customer reported that he found his laptop in his colleague’s office chambers; and offered to return the damage claim he had made. This was followed by similar behaviour by other customers.
Designing trust for Indian tax system
A simple approach for designing trust for Indian tax system is to either involve a third party or to make the taxpayer a participant in the application of revenue collected. The present taxation system in India is mired by conflict between taxpayers and government. An ideal environment to promote voluntary compliance is one that has both conflict and cooperation. Cooperation can come when the taxpayer is involved in the application of revenue collected by the tax department.
A simple proposal for doing this is to give points/credits to taxpayers. Similar to the way shopping complexes give credits on certain purchases to customers, the tax department can give credit to taxpayers. Illustratively, for every Rs. 1 Lakh paid, the taxpayer gets a credit of 10 points. Those who pay more than Rs. 50 Lakhs in any year get additional credits. The credits are added to the taxpayer’s smartcard (which will double up as a PAN identification). The credits can be used for availing of VIP or privileged services, such as:
More the credits an HNI accumulates, more will be their status in society: because credits are linked to philanthropy and status symbols. Philanthropic HNIs would be assured that their money is spent in funding a poor student’s education. Other HNIs would get to tweet their tea party with the finance minister.
Such pro-social behaviour will build trust in the middle class. They will gain trust in pro-social behaviour. Too many news items about cash seizures and I-T raids erodes their trust on the system. Too many tweets and public display of taxpayer credits by HNIs and corporates will build their trust. Many of them will start paying tax on their rental income and capital gains.
IP Migration, Equalisation Levy, and Trust
New business models arising out of digital commerce enable a firm to do business in India without having a permanent establishment in India. Indian taxmen have no jurisdiction over such firms. In late 1990s, many foreign e-commerce firms started doing business in India without having a base in India. This led to tax base erosion in India. Typically, they would be based out of a tax haven, and would maintain a subsidiary in India to provide routine support.
Their blatant act of tax avoidance encouraged many Indian firms to resort to externalisation. Externalisation is a process in which Indian firms open a parent company in a tax haven and migrate their Intellectual Properties (and other intangibles) to the parent company. IP is the only valuable asset of e-commerce companies, and income is primarily attributed to IPs. Once IP is migrated out of India, they too stop paying tax in India.
Indian tech companies felt a sense of relative deprivation on seeing foreign MNCs not paying tax while they have to pay tax. They resorted to externalisation to dodge the taxmen. India lost out on many valuable IPs that were incubated in tech hubs like Bangalore, Mumbai, and Gurgaon.
The CBDT constituted a committee, the Akhilesh Ranjan Committee on taxation of e-commerce, to investigate ways of taxing the digital economy. While the committee could not propose an easy way to tax digital economy, it proposed imposing of an indirect tax (equalisation levy) on overseas digital companies’ payments from India. An indirect tax as substitute for direct tax is never good economics. The committee too realised this and proposed equalisation levy as a stop gap measure till a final solution can be arrived at.
Equalisation levy was a game changer. Many tech start-ups who were contemplating IP migration to Singapore or Ireland changed their plans. Unfortunately, there is no detailed research on the impact of equalisation levy on taxpayer behaviour. Neither is there a quantitative research on IP migration after advent of equalisation levy, nor is there any qualitative research on business restructuring strategy after advent of equalisation levy.
In the absence of research results, we cannot be sure if equalisation levy increased the level of trust in domestic e-commerce companies. However, anti-abuse measures are generally associated with higher level of trust among taxpayers.
In conclusion, this essay does not delve into the effectiveness of deterrence measures such as penalty, prosecution, arrest, or naming-and-shaming on taxpaying behaviour. It analyses the impact of trust on voluntary tax compliance. It goes on to analyse ways and means of designing trust in tax system of India. One way is to convert the ‘conflict’ relationship between taxpayers and government into a ‘conflict and cooperation’ relationship. Taxpayers be given a say on the application of some part of tax paid for welfare. Credits can be given in return for tax payment, which could become a matter of vanity and prestige in society. Lastly, prompt anti-abuse provisions can improve the trust of taxpayers on efficacy of taxation system.
A word of caution is that policy design should be evidence-driven. The tax department or government think-tanks should sponsor studies and research to gauge the effect of pilot projects on trust quotient of HNI and small taxpayers.
1- See: https://en.wikipedia.org/wiki/Public_goods_game
2 – See: http://danariely.com/