Non-compliance with tax laws

By P. Guruge, Advisor, Fiscal Policy, Ministry of Finance

Types of non-compliance:

1. Non-declaration - This may include failure to register as required and even if registered the failure to furnish details (returns) as required.

2. Under-declaration - This will include under reporting of income or wealth or other tax base, over statement of allowances, credits, exemptions, etc. and applying wrong tax rates to reduce the liability.

3. Non-payment of tax due - This may be as ascertained by the taxpayer (self-assessment) or on an official assessment made.

Possible reasons:

1. Greed: No perceived benefit in exchange for tax paid.

2. Audit lottery: Perception that the taxpayer can get away with non-compliance due to low audit rate and taxpayers perception of inefficiency of the tax administration.

3. Need to hide illegal activities including financing of illegal activities.

4. To avoid the spillover effects - becoming liable to various other taxes and levies.

5. Ignorance of tax obligations - This may be very relevant in most developing countries. Lack of awareness.

6. The level of taxation is perceived as too high.

7. Complexity of the tax laws and procedures.

8. Low tax morality - no social stigma attached to non-compliance, national attitude toward tax obligation: Culture of evasion.

9. Perception of non-compliance by others - every one complains about non-compliance by others without looking at their own level of compliance.

10. The tax system is perceived as unfair.

These reasons may be grouped into a few common areas -

A. Social perceptions - This is the most difficult area to tackle. Changing social attitudes not only in the area of taxation but in other areas has become a difficult task. Greed, audit lottery, level of taxation, unfair tax system, low tax morality etc. may fall within this category.

This is because of the prevailing low morals or values among the people. However, in certain societies these problems may be overcome more easily than in the case of others. To correct this, many countries have adopted various methods and a few important ones are:

n Harsh sanctions and strict enforcement by administrative agencies and the judiciary.

n Publicity of non-compliance.

n Loss of civil rights - passports, drivers licence, business licence, etc.

n Educate taxpayers and their advisors.

n Appeal to social and political consciousness and responsibility.

n Research into types and causes of non-compliance and take remedial action accordingly.

B. Policy matters - Any tax system will be based on a set of clear policy guidelines. When these policies are decided it may be possible to consider some of these compliance aspects as well.

n Hiding illegal activities and financing illegal activities - This may be an area where the policy makers (not only the fiscal policy) should take some stand and deal with the problem in the national interest.

n Avoid the spillover effects - When a large number of different taxes are imposed very often on the same tax base or with connected liabilities the taxpayers may try to avoid all such taxes, even if they may like to fall in line with some taxes. In the context of Sri Lanka many say that they may be willing to pay NSL or GST since it is recovered from the consumer but that will have a bearing on their income tax liabilities. Similarly, when the turnover tax was very high on professional income, some did not declare part of their turnover to avoid high turnover tax and thereby avoided income tax too. Therefore, it is always better to have a few clearly defined taxes instead of having multiple taxes.

Level of taxation - This is another area where the policy makers should have a clear stand and take action accordingly. It may be difficult especially in the case of low-income developing countries to raise more revenue through taxation. When the tax instruments are selected it has to be done in an equitable manner so as to distribute the tax burden reasonably without depending entirely on the tax administration to ensure equity.

C. Administrative aspects - The main thrust in dealing with non-compliance will be in the area of tax administration. The enhancement of administrative capabilities (capacity building) in compliance enforcement may be the only way to tackle major issues involving non-compliance.

Basically this can be done in two ways:

i. Indirect activities:

(a) Withholding systems - Many tax administrations use tax withholding to achieve various objectives. In the US the sources of income subject to withholding taxes have recorded the highest (more than 90%) compliance rates. It is natural that the recipient of income which was subject to a deduction of tax will declare the correct amount in his declaration. However, in certain situations the taxpayers prefer to settle the full tax liability under the withholding system. Unless in a scheduled system of taxation, where each source of income is considered separately for tax purposes, this may not be possible. In the UK the PAYE scheme was designed to deduct the total tax liability on the employment income.

However, in Sri Lanka although a number of withholding systems are in operation only in one situation the tax withheld is considered as the final tax liability. That is the withholding tax payable on interest on compensation receivable from government, local government or public corporations on the acquisition of properties. Other withholding systems - dividends, interest, PAYE on employment income and specified fees, etc are not final tax liabilities. Some people mistakenly consider such deductions as final tax liability and do not declare such income in their returns or do not furnish returns at all in the belief that they have settled their tax liabilities in full. It may be important to consider this attitude of the public and make such withholding taxes final liabilities as far as possible.

(b) Information Reporting - Very often the relevant details of the persons from whom the tax has been deducted will accompany the remittance of tax withheld to the revenue authorities. Where the withholding is not the final tax this information can be used to take follow-up action on such persons.

In Italy the tax administration has the power to supersede the bank secrecy provisions for the purposes of assessment of direct taxes and VAT. Such power may be exercised only in the cases provided by the law.

Undercover operations by Inland Revenue officers and paid informants - This method has been used in the UK and many other countries. Officers posing as potential buyers will be able to detect under-reporting.

Making cash transactions more visible - In other words to discourage large cash transactions. However, it will be difficult to detect two party transactions although multiparty transactions may be detected. This can be done basically by information reporting of cash transactions above a certain amount and the restrictions on cash transactions in certain areas.

(c) Increased audit coverage and incidence:

This means the chances of increasing a win from the audit lottery. No tax administration will be able to do a 100% audit of taxpayers within a reasonable time frame. Therefore, it is necessary to design and execute an effective audit programme. For this the selection for audits is very crucial. Each and every taxpayer should have a feeling that the revenue official will knock at his door next morning. If they are insulated from this possibility for whatever the reason then the audit strategy will not be a full success. With a proper selection system a proper execution of the audit is very important. This should not amount to 'harassment' of the taxpayer. (However, 'harassment' is the buzzword of many taxpayers. Even calling for additional information is considered as harassment.

ii. Direct activities:

(a) Harsh sanctions and strict enforcement by administration agencies and the judiciary.

This is one area where many countries have failed to make any progress. The sanctions must be a deterrent. High fiscal penalties, imprisonment and closure of business activities are some such sanctions.

The biggest problem may involve the judicial process. The importance of a "revenue case" will diminish when the judicial process is started. Delays and other procedural impediments will not yield the expected results. Due to this certain countries have established separate revenue courts to try fiscal offences.

(b) Publicity of non-compliance - The effectiveness of this will again depend on the particular social and political set-up. If tax evasion is considered as bravery (in Italy it is said that tax evasion is the national sport) this type of action may not yield any results. Further, when a country confers honours to its citizens, their tax compliance history should also be considered.

Even in Sri Lanka the Commissioner General can publish the names of certain taxpayers who have been penalised for non-compliance and these details are published in the annual administrative reports. But, whether this has had any tangible result is a matter to be inquired into.

(c) Loss of civil rights - This is another effective area to be considered. Limitation of certain civil liberties may certainly have some impact. In many cases tax evaders are well-to-do people in society and they will not like to face such sanctions. Cancelling a passport or a driving licence or a business permit may affect them greatly. However, certain societies may consider such activities as a violation of fundamental human rights.

(d) Increase tax investigations - It is important to realise the difference between audits and investigations. In investigations the prime consideration may not be the collection of additional revenue but the imposition of sanction on the tax evaders. Therefore, it will have a better deterrent effect than audit where the main thrust may be to check whether the relevant taxpayer has complied with the legal requirements during any specific period.

However, in Sri Lanka this aspect of prosecution as a result of investigation has been neglected. Even after an investigation the prime concern seems to be the collection of additional revenue.

(e) Amnesty - In some countries where the administration and social attitudes are weak these amnesties are used to tackle non-compliance. However, the experience in Sri Lanka is a sad story.

The Taxation Inquiry Commission Report - 1967 states "we recommend that no further amnesties should be considered and that this fact should be made known to the public in no uncertain terms. An amnesty though its results may be impressive, discriminates against honest taxpayers and in the long run affects taxpayer morale".

In Sri Lanka we had a number of amnesties with different facets. We declared amnesties in 1964, 1965, 1970, 1971, 1978, 1989, 1990, 1992, 1993, 1997 and 1998 but still there is a clamour for tax amnesties. Out of these amnesties, demonetisation of large currency notes (Rs. 100/- and Rs. 50/-) in 1970 was a novel experience which added around 3,500 new taxpayers. In addition to these amnesties the system of Certificates of Deposits (CDD), bearer deposits without any name or identification introduced in 1981 has affected tax compliance further. By December 1982, Rs. 32 million was deposited in the CDD and this figure stood at Rs. 15,498 million in 1999. It is important to note that this figure has gone up to Rs. 18,894 million by December 2000.

Although the idea was to mobilise black money through the banking system some visible and taxable receipts may also have gone into these deposits. Further, certain sectors such as professionals may have used these CDD to hide a portion of their taxable earnings.

However, certain countries have used amnesties very successfully. This has happened where taxpayers believe tax administration has significantly improved to tackle the post-amnesty situations. If taxpayers perceive that a tax amnesty reflects shortcomings in tax administration and is likely to be repeated, they may reduce their compliance further precisely because tax administration appears weak and the risk of penalty is reduced by the likelihood of a future amnesty.

(f) Taxpayer education and assistance:

This is one of the most important aspects in compliance improvement. However, in many developing countries (including Sri Lanka) sufficient attention has not been paid to this aspect. Such countries have not provided sufficient staff and other resources for this purpose.

In actual practice, in many countries taxpayers are burdened with:

n complex and difficult to understand legislation,

n few or no guidelines issued by the tax department,

n little information is available as to the procedures to be followed,

n necessary forms are not easily obtainable,

n facilities to pay tax are inconsistent with the needs of the taxpayer, and

n unhelpful officials.

Simplified legislation and procedures are a pre-requisite for the implementation of a proper education programme specially when a number of tax statutes are operated simultaneously for different taxes, each such law should be clear and specific. When each law is not independent the taxpayer may find it difficult to understand it.

The structure of such laws may also create ambiguities. For example, for each revenue statute administered by the Inland Revenue Department (in Sri Lanka) there is a separate procedure of administration such as payment, penalties, prosecutions, etc. If these can be codified into a Taxes Management Act as in the UK it may be helpful to the administration as well as taxpayers.

Some of the legal requirements incorporated with a view to ensuring compliance sometimes have the opposite effect. For example, under the Inland Revenue Act (Sri Lanka) each and every company and non-company entities having turnover exceeding Rs. 5 million per annum should furnish a special audit report and specified schedules along with the return of income.

When one considers the number of approved accountants available, number of potential taxpayers and the due date of returns, compliance with this requirement may be practically impossible. Further the cost of compliance for some persons within adequate resources may be more than the tax liability itself. Therefore, it is very necessary to improve the existing legislation so as to help taxpayers to comply easily.

Along with these changes the tax departments should have programmes to educate taxpayers. Sometimes a particular tax administration may not be aware of the magnitude of evasion and how best that can be reduced with proper education programmes. Under any self-assessment system non-compliance stems from not knowing, initially.

In this context it is important to provide adequate guidelines to the tax advisors as well. The general level of competence of many tax advisors is not satisfactory. Many are not aware of the changes in law and the correct procedures.

(g) Tax discounts or other benefits for compliant taxpayers - Some may not agree with this on the basis that compliance is a requirement of law and therefore requires no additional incentives. However, as a matter of encouragement these may be considered. In France and Greece specific discounts are available.

(h) Tax compliance to be connected to prospective employment, tenders, business licences, etc. - Certain countries check for tax compliance of the family or the individual who applies for government vacancies.

Successful tax administrations have proved that the key to compliance is enforcement. The laws that are not enforced are not obeyed.

Finally, I wish to conclude this article with the following quotation:

"Make the evasion of taxes an even more painful process than paying them".