Abstract
The cost associated with adhering to the tax regulations imposed by the state is known as the compliance cost of taxation. This has emerged as a significant financial burden during the taxation process, particularly in the context of India’s tax system in recent years. Following the liberalization of the economy in the 1990s and the opening of markets to international trade, non-compliance with personal income tax regulations by individual taxpayers has seen a considerable rise in India, surpassing other countries with open and free-market economies. Consequently, it has become imperative to identify the underlying causes of this heightened non-compliance to safeguard a crucial source of the country’s revenue.
This research paper takes on the responsibility of examining one of the major factors contributing to non-compliance – the compliance cost of taxation. It is worth noting that this work is built upon a prior research article by Arindam Das Gupta on Compliance Costs of Taxation, which was one of the pioneering commentaries on the subject in a post-liberalized economy since 1990. Additionally, insights from the report produced by the Kelkar Committee, established by the Finance Ministry of the Government of India as a Direct Tax Task Force, have also been incorporated.
The scope of this article is primarily focused on the compliance of individuals with the tax system, excluding corporate entities and other legal persons. The objective is to assess the overall impact of compliance costs on a broader scale by applying determinants of compliance costs to various categories of taxpayers. This analysis aims to identify trends in compliance costs determinants and, subsequently, to estimate the compliance costs imposed on the entire demographic of the country. Ultimately, the goal is to identify effective measures, based on the findings, to alleviate the compliance cost burden on taxpayers.
Literature review: The book “Tax Compliance Cost: Measurement and Policy” edited by Cedric Sandford in 1995 serves as a comprehensive compilation of various studies and research conducted by a diverse group of policymakers worldwide. These studies originate from a conference that took place in September 1994, sharing the same theme as the book’s title. The primary focus of both the conference and the book was to explore the practical applications of measuring tax compliance costs in the context of policy development.
In a similar vein, “Compliance Cost and Taxation Impact Statement” authored by Chris Evans and Michael Walpole in 1996 and published in the Australian Tax Forum, serves as a compilation, review, and commentary on the tax administration and procedures of countries within the Organisation for Economic Cooperation and Development (OECD). This book delves into the intricate aspects of compliance costs and their significance within the realm of taxation, particularly within the framework of the Australian tax system.
Introduction
The definition of tax compliance cost, as articulated by the renowned British economist specializing in taxation and public finance, Cedric Sandford, in his book, can be summarized as follows:
“Tax compliance costs encompass the financial outlays borne by taxpayers in fulfilling the obligations imposed upon them by tax laws and revenue authorities. These costs are incurred in addition to the actual tax payments and any inherent distortions associated with the tax itself.”
The U.S. Internal Revenue Service (IRS) offers its own definition of taxpayer compliance, emphasizing the necessity for accurate and timely filing of all required tax returns in accordance with the Internal Revenue Code, along with relevant regulations and judicial interpretations.[1]
In simpler terms, the Taxpayer Compliance Burden, or Compliance Cost of Personal Income tax, can be defined as the resources, both in terms of time and money, invested by taxpayers to adhere to the tax system. This includes all the expenses shouldered by taxpayers to ensure tax compliance, encompassing financial resources, labor, and various inputs utilized by taxpayers.
In some instances, this can also encompass the fees charged by tax experts who provide advice on adhering to the most advantageous tax regimen to maximize benefits for the assessed individual. Going into greater detail, we can consider the financial and time investments in acquiring expertise about taxation systems, the cost of time spent on filing tax returns and data storage, expenses related to traveling and lodging when visiting revenue authorities, payments made to professionals and advisors, and incidental costs like postage and telephone bills. Cedric Sandford has also emphasized the inclusion of psychological costs, involving stress and distress experienced in managing one’s tax affairs, particularly for financially vulnerable groups such as pensioners, widows, divorced, and separated women, as part of the cost incurred during tax compliance in his earlier work.[2]
Compliance costs associated with taxes extend beyond taxpayers and affect various parties involved in the process of transferring funds from the private sector to the government’s coffers. This includes employers responsible for tax deduction at the source and financial institutions entrusted with tax collection, all of whom incur their own compliance costs.[3] The overall expenses of a tax system encompass a range of factors, such as welfare costs, opportunity costs, psychic costs, social costs, and more. To comprehensively evaluate the societal impact of taxes, it’s crucial to consider “the total sacrifice imposed upon the populace,” which includes collection costs, administrative costs, and compliance costs. Slemrod and Yitzhaki (1996)[4] identify compliance costs as one of the five component costs of taxation, along with administrative costs, the efficiency loss caused by taxation, the excess burden of tax evasion and avoidance costs.
Additionally, Sandford et al. (1989) stress the importance of accounting for the psychic costs associated with tax compliance, especially for vulnerable groups like poorer pensioners, widows, and single women. However, practical methods for quantifying these costs have proven to be challenging.
The extent to which an individual complies with the tax regulations of a state’s legislation is arguably the most pivotal factor in determining the Compliance Cost of Taxation. Typically, taxpayers aim to minimize the amount they owe to a tax regime to retain a larger portion of their earnings from their occupations, businesses, or professions. This intent naturally leads them to incur significant costs in the form of compliance expenses. Thus, it is reasonable to conclude that a taxpayer’s attitude towards complying with a tax regime and their assessment of the tax structure play a decisive role in determining the extent of compliance with a tax regime by an individual. The collective extent of compliance with a tax regime becomes a crucial factor to consider when measuring Tax Compliance.[5]
Although non-compliance with a tax regime by an individual taxpayer is often a deliberate and conscious act, there are instances where non-compliance occurs unintentionally or due to genuine mistakes. Unintentional non-compliance can be attributed to various reasons, including accounting errors resulting from carelessness, omissions, or misinterpretation of tax laws. Moreover, the complexity and ambiguity inherent in a tax system significantly contribute to unintentional errors and omissions. The process of acquiring the necessary knowledge about the tax system and the challenges associated with it can become quite daunting due to the reasons mentioned above, further fostering non-compliance with a tax regime.
Background
The study of compliance costs associated with the Personal Income Tax and the factors influencing them is a subject of increasing interest. Concerns about the costs incurred by taxpayers to adhere to tax laws, in addition to the taxes they pay, have become a topic of discussion among academics, policymakers, and the general public. This concern has even made its way into political agendas in countries like Australia and the United Kingdom. Several nations, including the USA, Australia, the UK, the Netherlands, New Zealand, and India, have explicitly addressed compliance costs in their policies.
The formal estimation of the overall compliance burden of the tax system can be traced back to Haig’s efforts in 1935, and more recent attempts have been made in various countries to compile annual indicators of compliance costs. However, some experts, like Sandford in 1995, argue that such annual indicators may not be reliable performance indicators due to significant margins of error. Nevertheless, when it comes to major tax reforms, changes in compliance costs have often been scrutinized.
While there has been a shift in emphasis from total compliance costs to assessing the impact of specific tax regulations, whenever a new revenue measure is introduced, a balance between administrative and compliance costs is crucial. In the UK, compliance cost assessments (CCAs) are now mandatory when introducing new tax proposals, and in Australia, changes in taxation legislation are supported by Taxation Impact Statements (TIS) to outline the impact on taxpayers, including compliance costs.
Although the terminology and interest in compliance costs are relatively recent, the underlying ideas have ancient roots. Three out of four of Adam Smith’s canons of taxation, “Certainty,” “Convenience,” and “Economy,” are directly or indirectly related to tax compliance costs, with the fourth being “Equity.”
High compliance costs have various economic implications, including deadweight resource costs, increased non-compliance, distorted production decisions, reduced investment, higher deficits, reduced tax equity, lower economic growth, and adverse price movements. Despite relatively efficient tax administration, the tax gap in developed countries remains significant, suggesting that the complexity of the tax system may be a major, often overlooked, contributor to large compliance costs, as suggested by Kaplow in 1995.
National tax systems frequently engage in direct competition as the tax burden plays a vital role in deciding where investments are made, especially in scenarios involving international competition for foreign investments. Compliance costs, by inflating the effective marginal tax rate, can introduce distortions and obstruct investment decisions, both at the domestic and foreign levels. Eland (1995) highlights that if a tax is levied during production or distribution, many current taxpayers may fall outside the tax scope, thereby reducing compliance costs. However, this comes with a trade-off, as the tax may impact prices early in the process and lead to more significant economic distortions, resulting in inefficient resource use.
Eland also points out that certain deductions, while increasing compliance costs, can introduce distortions. For instance, tax registration thresholds designed to exempt small businesses from taxation can distort competition around the threshold.
The examination of tax compliance costs can be valuable in tax design and policymaking by addressing questions such as:
– Do compliance costs have adverse equity effects, and are they regressive?
– Do high compliance costs diminish revenue collection and economic growth? Bardsley (1997) argues that reducing compliance costs primarily benefits small businesses, given their regressive nature. As small businesses are labor-intensive, lowering compliance costs is expected to positively impact employment, output, and consequently, economic growth. Moreover, high compliance costs can affect compliance and, thus, tax collection, potentially leading to adverse macroeconomic consequences through debt accumulation.
– Can high compliance costs promote non-compliance? High compliance costs have been identified as a factor contributing to non-compliance.
– Is there a need for assessing compliance costs concerning tax policy proposals, especially when such requirements are intended to bring significant benefits to taxpayers and society as a whole, albeit at a cost to taxpayers?
– Should compliance costs associated with new proposals be evaluated before implementing any tax policy, ensuring the effective enforcement of tax laws and compliance?
– What is the efficiency impact of compliance costs? Do they divert investments from sectors with high compliance costs to sectors with lower costs, leading to a misallocation of resources?
– Do compliance costs influence the effectiveness of macroeconomic policy tools? The connection between compliance costs and the efficacy of macroeconomic policy tools has not yet been extensively explored in the literature.
– Do compliance costs contribute to inflation? If prices are determined as mark-ups over costs, compliance costs can affect product pricing and the competitiveness of firms, particularly smaller ones.
The categorization of compliance costs
There are three main categories under which compliance costs can be grouped to facilitate the assessment of tax compliance. These categories, as outlined by various economists, including Amin Ali Talib, [6]are computational costs, planning costs, and advisory costs. The quantification of these costs is crucial because it directly impacts the implementation of economic and tax policies. For instance, a government’s tax policy aimed at simplification may reduce computational costs but increase advisory costs due to the uncertainties in the tax system.
Another approach to classifying compliance costs in taxation is based on the stages of tax legislation implementation. These stages are Commencement Costs, Temporary Costs, and Regular Costs, as identified by Evans and Walpole. Commencement Costs refer to the expenses incurred when new tax legislation is introduced. Temporary Costs occur during the transition to a new tax regime and affect both tax collectors and taxpayers.[7] Regular Costs are ongoing compliance expenses associated with adhering to the tax regime. This classification is valuable, especially in situations where tax legislation undergoes frequent changes, as it highlights the potential for higher costs in the commencement and temporary phases.[8]
An alternative classification of compliance costs in taxation, proposed by Mike Eland following the September 1994 conference on measuring Tax Compliance Costs, divides these costs into two main categories: Recurrent and Non-Recurrent. Recurrent costs include expenses typically incurred during tax filing, such as maintaining accounting systems, record-keeping, completing tax returns, and handling customs officer visits. Non-Recurrent costs encompass the expenses related to planning and preparing for new taxes, adapting existing administrative systems, staff training, and any additional costs that align with the taxpayer’s preferences and needs.
Factors Influencing Tax Compliance
(a) The level of compliance with a tax regime is significantly influenced by the attitude of taxpayers toward the tax system, tax legislation, and revenue officers, who represent the government. Taxpayers often consider the feasibility of tax evasion options and the potential punishment or penalties for such evasion. This consideration ultimately hinges on the effectiveness of tax enforcement.[9]
(b) The efficiency of tax enforcement, in turn, is affected by various factors, including the individual’s occupation, business, or profession. In some cases, corruption within the administration of tax law enforcement can be a significant factor contributing to voluntary noncompliance with a tax regime.[10]
(c) Another direct determinant of compliance with a tax regime is the tax burden. Heavy tax rates tend to discourage compliance, although the precise impact is theoretically indeterminate. Research suggests that heavy tax rates generally have a negative effect on tax compliance.
Advancements in technology, such as e-transactions through banking channels, have substantially reduced the cost of tax compliance and made it easier to monitor compliance. However, sophisticated financial systems have also created opportunities for cross-border tax evasion.
(d) The scale of transactions and the volume of transactions can be a critical factor in determining the compliance costs when reporting income taxes. Development associated with economies of scale in transaction size tends to reduce non-compliance. In other words, when transactions are larger and more streamlined, taxpayers are more likely to comply with tax obligations.[11]
(e) The distribution of wealth among individuals within a country is another determinant of taxation compliance costs. High industrial concentration means there are fewer large taxpayers in the economy, making the monitoring of these major taxpayers relatively easier than monitoring numerous small taxpayers with many small businesses.
(f) The timing of tax liabilities, specifically the frequency with which taxes must be paid to the government, is another important factor influencing compliance costs. For instance, when a business generates irregular income and is taxed frequently, such as on a monthly basis, it may affect the taxpayer’s attitude and increase the likelihood of non-compliance.
(g) Determinants of tax avoidance, including unnecessary deductions and exemptions, as well as ambiguous provisions in the tax code, directly impact tax compliance. The presence of necessary deductions and unnecessary exemptions can influence a taxpayer’s psychology and may lead to non-compliance with tax payments.
(h) Various cultural factors can significantly influence taxpayer attitudes towards compliance or non-compliance with a tax system. These factors encompass aspects such as fiscal knowledge, income, social class, risk aversion, race, age, gender, occupation, peer attitudes toward evasion and bribery, deference to authority, and familiarity with tax offenders.[12]
(i) In addition to deliberate misrepresentation, the complexity of the taxing system can induce non-compliance by causing misinterpretation of rules, omissions, and unintentional errors.
(j) A taxpayer’s perception of how efficiently the government utilizes their tax money psychologically influences their compliance with the tax regime. For example, if the government effectively employs taxes to provide a desirable mix of public goods, taxpayers are more likely to comply with tax obligations.
(k) Enhanced taxpayer service and the deliberate imposition of high compliance costs by the taxing authority can significantly influence individual tax compliance. Providing better service and making compliance more costly can promote greater adherence to tax obligations.
(m) The presence of a well-established accounting profession and tax preparers can encourage tax avoidance, especially among high-earning business individuals. This, in turn, may lead to a disposition toward non-compliance with the tax system.
(n) The costs associated with administrative proceedings, such as prosecutions, appeals, and scrutiny assessments, can be burdensome for taxpayers. Prudent taxpayers will seek to avoid incurring these follow-up costs, which may incentivize compliance with tax regulations.
Trends in Compliance Cost of Taxation
Based on empirical research conducted by the renowned Indian economist Arindam Das Gupta, who specializes in taxation and public finance, certain trends have consistently emerged within the Indian tax regime[13]. These trends align with the determinants of compliance costs in taxation and, further, with the factors influencing non-compliance with a state’s tax regime. These findings primarily stem from the evaluation of tax compliance in the aftermath of economic policy reforms during the 1990s, which opened the Indian economy to globalization. The striking resemblance between these trends in Indian tax compliance and determinants identified in studies conducted in foreign economies suggests that India has adopted a similar approach to economic administration as Western economies, progressing toward a more open-market system and globalization.
These trends can be categorized by the type of taxpayers. Salaried taxpayers exhibit lower compliance costs when compared to non-salaried taxpayers, who tend to face relatively higher compliance costs. This distinction can be attributed to a significant factor: the systematic and regulated record-keeping and reporting practiced by salaried taxpayers. Such practices streamline the tax filing preparation process, both reducing costs and psychologically discouraging taxpayers from engaging in tax evasion and non-compliance with the tax regime.
Another noteworthy trend in tax compliance is the positive correlation between a taxpayer’s income and their compliance costs. Typically, as a taxpayer’s income increases, their tax burden also rises when transitioning from one tax bracket to a higher one, leading to increased compliance costs. However, this upward trend in compliance costs follows a diminishing rate of increase as it approaches a certain saturation point.
In general, urban taxpayers tend to bear higher compliance costs compared to their rural or semi-urban counterparts. This disparity can be largely attributed to cultural factors and the intricacies of the tax system. Compliance costs often escalate in urban areas due to the availability of specific deductions exclusively applicable to urban and metropolitan regions, which increases the complexity of taxation and, consequently, compliance costs.
Taxpayers who are well-informed about the country’s tax system typically pay less in taxes compared to those who are less educated or completely unaware of the tax regime. This is primarily because the complexity of the tax system tends to drive up compliance costs. Additionally, this situation creates opportunities for tax experts and accounting professionals to thrive and provide their services to taxpayers.
Case study
The cost of deducting taxes at source: The expenses associated with deducting income taxes at the source (TDS) form a significant part of third-party compliance costs. In the fiscal year 1999-2000, collections through TDS accounted for 53 percent of the total income tax collection and 60 percent of income taxes from non-company sources, as reported by the CAG in 2001. The relatively low compliance costs for salaried individuals are attributed to their employers assuming the responsibility of assessing tax liabilities and preparing tax deduction statements (Form 16A) for their employees. A case study illustrates this point.
Three categories of TDS compliance costs were identified: (A) external costs, including fees paid to external Chartered Accountants, (B) staff costs, which encompass the expenses incurred by the accounts department to complete and submit TDS returns, deposit TDS, and prepare Form 16A for employees, and (C) overhead administrative expenses, which involve computer costs for TDS returns and Form 16A, photocopying, postal and fax expenses, travel and conveyance, pro-rated office space at market rental rates, general supplies, stationery, consumables, maintenance, and the purchase of tax publications and journals. These costs are detailed in Table 24.
For the fiscal year 2000-01, the total amount of income taxes deducted at the source was Rs. 8,92,768. The table estimates the total compliance costs at 11.81 percent of taxes deducted at the source.
This aggregate estimate is influenced by several factors. If the average number of income tax-paying employees per organization is less than 70 and if there’s a wide distribution of organizations by the number of tax-paying employees, the estimate may be biased downward. Additionally, the cost of TDS for interest and dividend income is likely lower per taxpayer than for salary income. Assuming that 60 percent of taxes are collected through TDS, with 80 percent of TDS related to employment income and the cost of TDS for other income being 0.5 percent of taxes collected, the estimated TDS compliance costs are (0.6)(0.8)(11.81) + (0.6)(0.2)(0.05), which amounts to 5.68 percent of tax collections.
Suggestions
The survey highlights the substantial compliance costs associated with personal income tax, both in comparison to international standards and other potential funding sources in India. The primary contributor to these costs is the Department’s widespread corruption, as identified by the study. However, the main factors leading to high compliance costs are convoluted procedures and, to a lesser degree, the specific tax regulations.
To address this issue, a six-pronged strategy is proposed to lower the operational expenses of personal income tax. This strategy includes simplifying the tax structure, implementing institutional reforms, streamlining procedures, embracing automation, enhancing monitoring and obtaining client feedback, and reforming tax policy processes. If, after approximately three years, these measures do not significantly reduce compliance costs, more substantial tax reform might be necessary to alleviate the societal burden of government revenue collection.
It’s important to note that tax structure simplification, as recommended by the Direct Tax Task Force in 2002, is a separate topic and is not discussed in detail here as it broadly aims to reduce the complexity of the income tax system.
Conclusion
Considering all the data discussed, including the determinants affecting tax compliance, the application of these determinants to a tax regime, and the overall compliance trends related to the demographics of taxpayers, it is evident that the compliance cost of taxation in the Indian tax system is exorbitant, especially when compared to international standards. This high compliance cost places a significant tax burden on individual taxpayers, making non-compliance an appealing option. It’s important to note that there are also psychological costs associated with this issue, further exacerbating the problem of tax non-compliance.
Additionally, corruption within government taxing and revenue departments only encourages ordinary taxpayers to evade tax compliance. Cumbersome procedures and complex legislative provisions further compound the issue. Therefore, it becomes the government’s responsibility to address this problem, increasing individual accountability and ensuring proper tax collection.
By achieving 100% compliance from every taxpayer, the government can secure more tax revenue, boost the country’s GDP, and have greater funds available for public finance. This benefits taxpayers as the country’s economy advances, individual buying power increases, and the government can provide more welfare projects.
The Kelkar Committee, established by the Government of India’s Ministry of Finance in 2002 to address non-compliance of taxation, made several important observations. These include recommendations for tax structure simplification, institutional reforms, procedural reforms, enhanced monitoring, client feedback procedures, tax policy process reforms, and automation. While there has been some progress in addressing the issue, core problems remain unresolved. For example, corruption persists due to excessive discretion among low-level officers with limited accountability, a culture of bribery, and an outdated organizational structure. These issues can only be effectively addressed through institutional and procedural reforms.
Simplifying the tax structure would improve compliance among undereducated taxpayers who are unfamiliar with the tax regime, while automation would reduce many intermediate costs associated with tax compliance. Implementing client feedback procedures would reduce corruption and encourage taxpayers to comply with the country’s tax system. In essence, a step-by-step tax policy process reform is essential to address the country’s tax compliance challenges.
Bibliography
Books
1. Tax Compliance Costs: Measurement and Policy by Cedric Sandford (1995), Bath U.K.: Fiscal Publications in association with The Institute for Fiscal Studies.
2. Linkages between Compliance Costs and Taxpayer Compliance Research by John Hasseldine (2000), paper presented at ATAX Compliance Cost Symposium, Sydney, 26-27 April.
3. Administrative and Compliance Taxation by Cedric Sandford, Michael Godwin, Peter Hardwick (1989), Bath, UK: Fiscal Publications.
4. Compliance Cost of Taxation by Amin Ali Talib (1996), Bulletin for International Fiscal Documentation, 50, September, 418-421.
5. Compliance Cost and Taxation impact Statement by Chris Evans and Michael Walpole (1996), Australian Tax Forum, 13 227-274.
6. Tax Compliance Costs: the Problems and the Practice – Customs and Excise by Mike Eland (1995), Bath, U.K: Fiscal Publications in association with The Institute for Fiscal Studies
Articles
1. Compliance Cost of Personal Income Tax and its Determinants by Arindam Das Gupta and Saumen Chattopadhyay (2002) pg 39, 66, National Institute of Public Finance and Policy, New Delhi
2. The Personal Income Tax in India: Compliance Costs and Compliance Behaviour of Taxpayers by Arindam Das Gupta and Saumen Chattopadhyay (2002) National Institute of Public Finance and Policy, New Delhi
3. A Theory of Hard to Tax Group by Arindham Das Gupta (1994), Public Finance 49, (Supplement), 28- 39, Proceedings of the 49th Congress of the International Institute of Public Finance, Berlin 1993.
[1] Linkages between Compliance Costs and Taxpayer Compliance Research by John Hasseldine (2000).
[2] Tax Compliance Costs: Measurement and Policy by Cedric Sandford (1995).
[3] See, Evans and Walpole (1997)
[4] See, Mikesell (1986).
[5] Administrative and Compliance Taxation by Cedric Sandford, Michael Godwin, Peter Hardwick (1989
[6] Compliance Cost of Taxation by Amin Ali Talib (1996).
[7] Compliance Cost and Taxation impact Statement by Chris Evans and Michael Walpole (1996).
[8] Tax Compliance Costs: the Problems and the Practice – Customs and Excise by Mike Eland (1995).
[9] The Effects of Tax Reform on Tax Evasion by Ian Wallschutsky (1988).
[10] Voluntary tax compliance behaviour of Spanish income taxpayers by de Juan, Ana, Miguel A. Lasheras and Rafaela Mayo (1994).
[11] A Theory of Hard to Tax Group by Arindham Das Gupta (1994).
[12] Why People Pay Taxes: Tax Compliance and Enforcement by Joel Slemrod (1992).
[13] Compliance Cost of Personal Income Tax and its Determinants by Arindam Das Gupta and Saumen Chattopadhyay (2002).
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