As I write this editorial, the Union Budget for 2009-10 is
yet to be presented, but will be in your hands before you read this (since this
Special Issue is being released at the AGM on 10th July). Expectations from this
budget are running high, particularly as the newly re-elected Congress
Government is no longer constrained by pulls and pressures from its allies.
Perhaps the public expectations are running too high, given the constraints on
Government finances and the worldwide economic recession. Also, the short time
between the swearing in of this Government and the presentation of this budget
leaves very little scope to actually carry out any major changes. This Budget is
therefore more likely to express the intentions of the Government to carry out
further changes over the next five years, rather than actually effect any
immediate major changes.
On the taxes’ front, as usual, various rumours of expected
changes are doing the rounds, ranging from drastic changes such as abolition of
Fringe Benefit Tax to minor changes such as restricting allowability of
depreciation to Charitable Trusts. We have got so used to numerous amendments to
tax laws carried out through the Finance Act each year, that we take such
changes for granted.
The Government has been talking of simplification of tax laws
for the past several years, and has been deleting various incentive provisions
every year with this stated objective. The justification for simplification of
tax laws is that it will improve compliance on account of better understanding
of tax provisions. Does simplification really serve this purpose ?
A recent research paper on Behavioural Economics and Tax
Policy presented at the National Tax Association’s 2009 Spring Symposium in USA
by two researchers from the Brookings Institution and a Professor at Harvard
University does raise some doubts about such claims. This paper points out that
the standard economic assumptions about individual behaviour are not accurate,
and that behavioural economics shows that people do not act rationally, that
they are not perfectly self-interested and that they hold inconsistent
preferences. Using these findings of behavioural economics would lead to more
effective tax policy, from the perspective of welfare consequences of taxation,
use of the tax system as a platform for policy implementation and using taxes as
an element of policy design.
Tax efficiency depends on the elasticity of the response to
tax rates. Since elasticity is really a parameter derived from a behavioural
response, and behavioural economics shows that how people respond to taxes is
less straightforward than what is normally presumed, the rationale for tax
simplicity needs to be re-examined.
Normal policy dictates that the recipe for good taxes is that
they should be simple, they should impose low rates on wide bases, and in case
of taxes on goods, they should be imposed on goods for which the demand is
relatively inelastic. Simplicity is associated with efficiency. The view is that
low tax rates on large bases are simpler as compared to taxes with many
exemptions from income, which leads to smaller bases and higher tax rates.
Complex taxes increase the cost of tax compliance and administration. Provisions
complicating the tax laws are often seen as being more politically motivated,
than economically justified.
Behavioural economics shows that individuals respond to tax
rates not as they are set, but as they construe them. Complex or obscure taxes
may not be perceived accurately or may be ignored. Therefore, the elasticity to
such taxes is low, making such taxes efficient. For example, sales tax which is
a part of the commodity price, is often ignored by taxpayers. Similarly, if a
separate tax is raised for a specific purpose, though it complicates tax laws,
behavioural economics shows that taxpayers associate that particular tax with
the intended benefit, leading to better compliance.
Balancing tax complexity with tax fairness is another area
where behavioural economics can contribute. The fairest tax code is normally not
the simplest. Adding fairness to a tax system adds to the complexity, but
taxpayers generally prefer an equitable or fair tax system though it adds
complexity, as behavioural economics shows that they care about the welfare of
others and are not perfectly self-interested.
Behavioural Economics also shows that implementation of
non-tax policies along with tax laws is easier, since the process of filing of
returns and payment is almost automatic compared to other government procedures.
It is therefore far easier to implement such programmes through tax laws, rather
than have a separate procedure for such programmes.
Another area where behavioural economics is of help is by
showing that tax reductions structured as bonuses are more likely to be spent by
taxpayers, than if structured as tax rebates. Similarly, a reduction in tax
deduction rate is more likely to be spent by taxpayers, rather than a lump sum
reduction. This understanding facilitates structuring of reduction in taxes by
the Government, where the intention is that the tax savings should be spent by
taxpayers in order to boost the economy.
This study serves as a beginning to understand the nuances of
taxpayer attitudes to tax laws, which are not as rational as made out to be so
far. This certainly raises many more questions in relation to the current
perceived wisdom, particularly as to whether simplification of tax laws is
desirable if it is at the cost of fairness.
