There are two primary ways of improving tax collection: creating deterrence and promoting voluntary tax compliance. Many strategies have been used in the last five years to create deterrence, such as effective benami law, strict law on foreign assets and investigation of demonetisation-related cases. These measures yielded good results: taxpayer base increased by 80 percent between FY2013 and FY 2017. Yet deterrence has limited efficacy.
Some policy analysts believe voluntary tax compliance is a myth; the taxpayer has an inherent tendency to evade. This argument is fallacious, as taxpayers do pay tax voluntarily when they trust the system. Trust is critical for voluntary and cheap compliance. A simple illustration is a business that does not involve trust between the two parties. They have to hire advocates to draw lengthy contract. This increases the cost of doing business for both the parties. Likewise, trust between the government and citizens makes tax compliance cheap and effortless. But how to design a tax system that inspires trust?
The public goods game
The public goods game is a basic game in experimental economics. In this game, all members of the 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.
One day, a member does not contribute to the pot in the morning but receives a share of the produce in the evening. Other members realise that one member has not contributed. Trust breaks and the following day, no one contributes. It becomes a lose-all situation.
In this game, there are only two equilibriums. All participants benefit from the first equilibrium, while all participants lose from the second one. It is easier to move from the first equilibrium to the second but difficult to move back from the second to first equilibrium, i.e. it is difficult to regain trust.
This game tells how citizens rationalise evasive behaviour. High networth individuals (HNIs) and business promoters allege that the government does not appropriately use tax collected in welfare and public amenities. They perceive a high degree of corruption in handling of tax money. This helps them rationalise tax evasion.
The salaried class feels that HNIs 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. They then tend to evade tax on capital gains (from sale of property), house rent, and interest income.
The solution is two-pronged: Develop trust between taxpayers and tax department, and develop trust among taxpayers about compliance of HNIs and corporates.
How do we design a system to develop this trust? Dan Ariely, a professor of behavioural economics at Duke University, reasons that trust between two parties can be improved by bringing in a third party whom both trust.
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.
A simple way of doing this is to give points/credits to taxpayers. Illustratively, for every Rs 1 lakh tax paid, the taxpayer gets a credit of 10 points. Those who pay more than Rs 50 lakh in any year get additional credits. The credits are added to the taxpayer’s smartcard (which doubles up as PAN identification). The credits can be used for availing of altruistic services or vanity access, 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. Too many news items about cash seizures and I-T raids erode their trust in the system. Regular 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.
The writer is author of Loophole Games: A Treatise on Tax Avoidance Strategies. Views expressed are personal.
Read Smarak Swain's columns here
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