Effects of tax payment systems on tax compliance

- Comparing the advance tax system with the end-of-period system -

05/06/2015

Université Paris I Panthéon-Sorbonne – Université Paris Descartes

Mariko Shimizu

UFR 02 sciences économiques

Année de soutenance (2014-2015)
Master2 Economics and Psychology

Supervised by Pr. Nicolas Jacquemet

Juried by Pr.  Samira Bourgeois and Pr. Louis Lévy-Garboua

 
  

 
 
 

L'université de paris 1 Panthéon Sorbonne n'entend donner aucune approbation ni

désapprobation aux opinions émises dans ce mémoire ; elles doivent être considérés

comme propres à leur auteur.

 
  

Table of Contents

Acknowledgments   ii  
Abstract   iii  
Introduction   1  
Theoretical  background   4  
I.  Tax  Evasion  under  Expected  Utility  Theory   4  
II.  Deviation  from  the  Expected  Utility  Theory   5  
III.  Tax  Evasion  under  Prospect  Theory   6  
a. Adaptation to the paradox of A&S, A&S/Y Model   7  
b. Advance tax   7  
Hypotheses  and  overview  of  the  study   13  
I.  An  illustrative  theoretical  model   13  
II.  Hypothesis   16  
Experimental  design  and  procedures   21  
I.  Tax  game   21  
II.  Risk  attitude   24  
III.  Participants   24  
Result   25  
I.  Verification  of  hypothesis   25  
II.    Risk  attitude  and  Tax  evasion   29  
Discussion  and  conclusion   31  
Tables  and  Graphs   36  
Referenced   39  
Appendix  A.  Tax  evasion  under  Expected  Utility  Theory   44  
I.  Allingham  and  Sandmo  Tax  Compliance  model   44  
II.  The  expansion  of  the  A&S  model  -­‐  A&S/Y  model-­‐   47  
III.  Advance  tax   47  
Appendix  B.  Tax  rate,  Fine  rate  and  Audit  rate   48  
Appendix  C.  Experiment   52  
I.  Experiment  instruction   52  
II.  Examples  of  tax  game   54  
 

  i  
  

Acknowledgments

This research was achieved thanks to the Pr. Nicolas Jacquemet’s support. I also
thank my classmates of Master 2 Economics and Psychology. They cooperated to my
experiment, and always gave me good advices.

I thank Pr. Lévy-Garboua for his assistance in the field of risk aversion and loss
aversion, and Pr.Vergnaud for his comments that greatly improved the main idea of
this thesis.

I am also immensely grateful to Michaël Tiralongo, my husband, for his comments on

an earlier version of the manuscript.

  ii  
  

Abstract

We highlighted the differences in individuals' tax compliance in two different

existing tax systems: the advance tax system and the end-of-period system.

Under the expected utility theory, there is no difference between the advance

tax system and the end-of-period system. Since prospect theory, which was proposed

by Kahneman and Tversky, has been introduced to the tax compliance theory, many

scholars showed that the overwithheld advance tax induces higher tax compliance

than the underwithheld advance tax. However, nobody has dealt with the differences

in tax compliance between the advance tax system and the end-of-period system.

We made a simple decision-making model under the prospect theory and

predicted that the advance tax system induces higher tax compliance than the end-of-

period system. The difference of the reference point in these two taxation systems

results in two different value-functions, leading to different subjective values in the

advance tax system and in the end-of-period system.

The result of the experiment supported all our hypotheses. Furthermore, we

show that the positive effect of the advance tax system on tax evasion does not

dissipate by repetition.

  iii  
  

Introduction

“In this world nothing can be said to be certain, except death and taxes.”

- Benjamin Franklin -

Benjamin Franklin is one of the most famous American politicians of the end

of the 18th century, and he is respected as one of the Founding Fathers of the United

States. We can see from his sarcastic quote that it is the same now as formerly that

some low morale people avoid their tax despite most of people paying their tax with

certainty. Government should decrease the tax evasion not only for their revenue but

also for the people who pay their tax. Therefore, policymakers should find a good

approach to improve tax compliance.

Nowadays, there are two main systems to collect income tax: (1) the income

tax is first withheld from taxpayer's income compulsorily or optionally, and at the end

of the tax period, adjusted by taxpayer's declaration (hereunder “advance tax system”).

(2) Taxpayers pay all of their taxes at the end of the taxation period (hereunder “end-

of-period system”). Some countries use the former system (for instance Japan,

Sweden), some use the latter system (for instance France), and other countries use

both systems (for instance, the United States). In economics using the expected utility

theory, there is no difference in the model of individuals' decision-making between

both systems (Yaniv, 1998,1999).

  1  
  

Prospect theory has brought a new wave to the study of tax compliance.

Daniel Kahneman and Amos Tversky proposed the prospect theory at 1979, and

adapting it to the study of individual behavioral model regarding tax.

In the field of mathematization of individuals' decision-making model

regarding tax, many scholars tried to solve the paradox of the existing theory under

the expected utility theory, which had been mainly developed by Allingham and

Sandmo (1972), and Yitzhaki (1974).

Besides, empirical studies, both using the statistical method and the

experimental method, have been mainly focused on the advance tax, and they clearly

indicated that the difference of the taxation system affects the taxpayer's decision-

making. The statistical studies found that taxpayers who were underwithheld at filing

were more likely to understate their income than taxpayers who were overwithheld

(Clotfelter, 1983; Chang and Schults, 1990; Engström et al., 2013; Rees-Jones, 2014,)

An experiment study that replicated the taxation system compared the two above

situations, and it showed the significant effect of the withholding position on tax

compliance (Robben et al., 1990; Schepanski & Kelsey, 1990).

However, most past studies about the advance tax system focused only on the

differences between the overwithheld situation and the underwithheld situation, even

though the taxation system might make the difference in the individual's tax morale.

Past studies showed clearly that in the advance tax system, the overwithheld situation

resulted in taxpayers’ higher tax compliance than the underwithheld situation, but

there is no study that try to show how the differences between the advance tax system

and the end-of-period system affect individuals’ tax morale.

  2  
  

Studying the differences in tax compliance between the advance tax system

and the end-of-period system is important for making more efficient tax policies,

because the difference of those two system might affect the individual's decision

making about tax compliance.

Our aim in this paper is to highlight that different tax systems result in

differences in individuals' tax morale. In the chapter of theoretical background, we

will study the big picture of this field and clarify the subject matter by summarizing

the history of past studies about tax compliance under the expected utility theory and

the prospect theory. Next, we will apply prospect theory to a simple model of

decision-making, and provide the predictions for our experiment. To investigate this

prediction, we will run the experiment, which consist of the tax game and the risk

attitude test. Then finally, we will analyze our result and discuss about the difference

of those two-taxation systems.

  3  
  

Theoretical background

 
I. Tax Evasion under Expected Utility Theory

 
How to improve the people's tax morale is a big matter not only for the

government but also for the citizens who pay their tax. In the last decades, the study

of tax evasion in economics mainly developed based on the Allingham and Sandmo

(1972) model under the expected utility theory (hereafter abbreviated A&S model).

They showed clearly the decision strategy of the taxpayer. However, they did not

make clear how tax rate influence tax paying rate or tax evasion. Yitzhaki (1974)

expanded their theory based on the actual scheme in the United States (hereafter

abbreviated A&S/Y model). The difference between A&S model and the A&S/Y

model is that the penalty of the tax avoidance is decided not based on the undeclared

income, but based on the concealment tax. According to his changes of the penalty

rule, when assuming that the taxpayer is risk aversive, the relation between the tax

evasion and tax rate became clear; the increase in the tax rate raises the tax

compliance (called Yitzhaki puzzle). The Yitzhaki puzzle should be understood as a

pure income effect (Piolatto and Rablen, 2014). However, this result is different from

the observation of the empirical analysis study (Clotfelter, 1983; Poterba, 1987).

Furthermore, A&S model and A&S/Y model have another paradox: if we use

the observed values for their equation, it is expected that between 91 and 98.5 percent

of people would commit tax evasion, although empirical analysis shows that it is

extremely low (Dhami and al-Nowaihi, 2006). Hence their results have been called

the “big argument”. The detailed explanation of both the A&S model and the A&S/Y

model are shown at the Appendix A-I, II.

  4  
  

Besides, Allingham and Sandmo were also criticized because their model does

not capture all motivations for tax compliance (Luttmer and Singhal, 2014), writing:

“This is a very simple theory, and it may perhaps be criticized for giving too little

attention to non-pecuniary factors in the taxpayer’s decision on whether or not to

evade taxes.” (Allingham and Sandmo, 1972; p326).

II. Deviation from the Expected Utility Theory

 
As Allingham and Sandmo predicted, scholars found many motivations for tax

evasion. One of the fields that made the biggest achievement to find the motivation of

the tax evasion may be the statistical analysis (Aml and Torgler, 2006; Cummings et

al., 2009; Martínez-Vázquez and Torgler, 2009; Torgler, 2004; Torgler, 2005a;

Torgler, 2005b; Torgle, 2006; Torgler and Schneider, 2007).

From those results, Lago-Peñas and Lago-Peñas (2010) argued that those

results contained four major themes. First, socio-demographic characteristics, such as

gender, age, marital status, education, employment status, religiosity, and social class

are considered. A second group of variables include political and social attitudes; for

instance, trust in the courts, legal system, politicians and democracy in general,

national pride, social capital (trustworthiness), the perceived level of corruption, and

voting behavior. Third, variables measuring the fiscal parameters that determine

deterrence are included: tax rates, the fine rate, audit probability, risk aversion, and

also personal income. Finally, contextual-level variables have been included to

control for national differences related to the extent of direct democracy, language

fragmentation, culture, or the existence of regional cleavages.

  5  
  

The psychologists also intended to find the motivation for tax evasion. They

approached tax compliance from psychological factors, and they found that the

individual perception of fairness (Eriksen and Fallan, 1995), the perception of

inequity to the other tax payers and the government (Bazart & Bonein ,2014) and the

individual's trust to the government (Kirchler, Hoelzl and Wahl, 2008; Prinz,

Muehlbacher, & Kirchler, 2014) affect the individual's tax compliance behavior.

III. Tax Evasion under Prospect Theory

 
The studies we showed above revealed that a lot of factors affect the

individuals’ taxation decisions, but these findings had not changed drastically the

individuals' tax evasion model that was proposed by Allingham and Sandmo, and

Yitzhaki.

The big change to the individual's tax compliance model was brought by the

prospect theory proposed by Daniel Kahneman and Amos Tversky in 1979. As

difference from the expected utility theory of the prospect theory, it makes the S-

shaped individual's utility function steepest at the reference point. People perceive

outcomes as gains and losses compared to some reference point rather than caring for

the final state of their total wealth (a phenomenon called “preference dependence”).

Under prospect theory, as people feel loss as more salient than gain, the shape of the

function is steeper in the negative than in the positive domain; losses loom larger than

corresponding gains (referred to as “loss aversion”) (Kahneman and Tversky, 1979).

Since Daniel Kahneman and Amos Tversky defined the prospect theory, a lot

of scholars tried to introduce it to the economical model. The tax compliance model

was also no exception, and this adaptation opened the door to a deeper understanding

  6  
  

of the individual's tax compliance behavior. The stream of the tax compliance theory

under prospect theory was divided mainly in two directions: (1) trying to solve the

paradox of the A&S model and the A&S/Y model, and (2) adapting it to the advance

tax system that was thought not different from the end-of-period system under the

expected utility theory.

a. Adaptation to the paradox of A&S, A&S/Y Model

Alm et al. (1992) were the first who studied the paradox of the A&S model

and the A&S/Y using prospect theory. They conjectured that taxpayers might be using

a non-linear transformation of probabilities to overweigh the probability of a tax audit,

which provides for an obvious deterrent to tax evasion activity. As expected, their

results suggested that tax compliance occurs because some individuals overweigh the

low probability audit. Furthermore, they succeeded to show that the evasion rate in

their experiment was closer to the empirical data than the rate that we could get from

the A&S model and the A&S/Y, by way of experiment.

Piolatto and Rablen (2014) tried to solve the Yitzhaki puzzle. They provided a

calculation analysis of the conditions under which evasion increases in the tax rate

when agents behave according to prospect theory. From this analysis, they found that

the existing application of prospect theory to tax compliance do not convincingly

resolve the Yitzhaki puzzle.

b. Advance tax

Under the expected utility theory, advance tax payments play no role in the

taxpayer's evasion decision, because advanced tax is cancelled out in the individual's

expected function (i.e. Appendix A-III; Yaniv, 1998,1999), despite the empirical

  7  
  

analysis showing the relation between advance tax payment and tax evasion. For

instance, Clotfelter (1983) and Chang and Schults, (1990) researched a "withholding

phenomenon" using data from the Taxpayer Compliance Measurement Program

(United States). Both of two studies found that taxpayers who had their advance tax

underwithheld were more likely to understate their income than taxpayers who had it

overwithheld.

The study by Robben et al. (1990) for a large number of countries (Belgium,

the UK, the Netherlands, Spain, Sweden, the United States) showed clearly that the

"withholding phenomenon" does indeed occur. Elffers and Hessing (1997) showed

that advance payment promotes compliance by analyzing data of Dutch taxpayers.

Engstrom et al. (2013) also researched statistical data in Sweden, and showed that the

overwithheld tax would sharply decrease the claims for deductions.

The studies by way of laboratory experiments also supported the empirical

results we showed above. Robben et al. (1990) showed that the gain and loss

frameworks affect the tax compliance by way of laboratory experiment. They

replicated the business dealing of a small company and the subjects had to manage

their business on their own. The tax was withheld according to their business results

and at the end of each year they had to complete the tax form. The situation consisted

of three outcomes: refund (gain), neutral (neither refund nor additional payment) and

additional pay (loss). Their result showed that those participants who were recalled

having to make an extra payment evaded taxes more often than those who recalled

receiving a refund.

Schepanski and Kelsey (1990) also tested this phenomenon as framing effect.

They made a loss framing condition and a gain framing condition, and they measured

  8  
  

the subjects' risk-attitude in each condition. The result showed that the subjects in the

refund condition were more risk averse than those in the loss condition.

Yaniv (1998,1999) formalized the individual's payoff under the prospect

theory to take into account the individual paying of the advance tax. We will briefly

explain his theory: Now we assume that the reference point in making a decision is set

at the individual's current financial situation (Now we assume that it is the end of the

taxable period, just before the final tax return). When people pay too much advance

tax during the taxable period, they get a refund and it is considered a gain. When

taxpayers pay an advance tax that is lower than the tax they owe, they have to pay the

difference at the end of the taxable period and it is considered a loss.

Now we assume that individual's has the S-shaped utility function steepest at

the reference point: concave for gains (implying risk aversion) and convex for losses

(implying risk seeking). When a taxpayer is in the loss domain, he might be more

willing to take the risk of evading, therefore the additional tax enhancing compliance.

Oppositely when he is in the gain domain, he might be more willing to adopt a risk-

adverse stance, therefore paying too much advance tax promotes compliance.

As a derivative of this theory, there is the argument about the reference point.

Schepanski and Shearer (1995) are the first scholars who focused not only on the

effect of the over and under withholding situation but also on the matter about the

position of the reference point by way of experiment.

According to them, two major theoretical possibilities can be retained. One

possible reference point is the expected asset position at the time of filing. In this case,

the reference point would be taxpayer's expected total liability less the expected

  9  
  

amount withheld at source for the year. Accordingly, a payment due at filing that

exceeded what was expected or a refund due that fell short of what was expected

would both be framed as losses, while a payment due less than what was expected

would be framed as gains. However, if expectations are not included in the tax

balance, current asset position is another possibility. In this case, taxpayers who are

underwithheld at the time of filing would have an additional payment due which

would be framed as a loss, whereas overwithheld taxpayer would have a refund due

with would be framed as a gain. Their result showed that the taxpayer's reference

point tend to be employed when making tax reporting decision is better represented

by current asset position than by expected asset position.

Elffers and Hessing (1997) also suggest that the reference point should be the

income after the payment of the advance tax and prior to the filing of a return, and

Yanvi (1998, 1999) modeled the individual's tax compliance behavior based on this

point of view.

Besides, Dhami and al Nowaihi (2006) argued that legal after-tax income

should be used as the reference point. This is related to the idea that the reference

point should be based on rational expectations (Köszegi and Rabin, 2006), i.e., how

much the taxpayer expects to owe or to get refunded.

Kiechler and Maciejovsky (2001) showed the possibility that the reference

point would be changed depending on the habitual decision making framework by

way of experiment. They investigated the self-report tax evasion on the self-employed

and the business entrepreneurs. They observed that for the self-employed in the study

an unexpected surprise payment leads to low tax compliance, whereas an unexpected

surprise refund leads to high tax compliance. By contrast, for the business

  10  
  

entrepreneurs in the study an expected payment associated with low tax compliance,

and expected refunds were associated with high tax compliance. Thus, the self-

employed's self reported tax compliance can be described by the current asset position,

and for the business entrepreneurs' self reported tax compliance can be described by

the expected asset position. From those results, they pointed out that both asset

positions are commonly used, then which position would be used depend on the

habitual decision framework of the individual and his/her expectation.

Another derivative of this theory, the people's preference between the advance

tax system and the end-of-period system was investigated. (Ayers, Kachelmeier and

Robinson, 1999). From this study, it has been clear that people have the tendency to

prefer overwithheld taxation, and half of their subjects wanted to pay more than the

minimum amount. The degree of uncertainty about estimating the current-year tax

liability significantly pushed up the propensity to overpay on an interim basis, but the

effect that make them willing to pay more than the minimum amount diminishes with

taxpayer's experience. Besides, their preference of the advance tax was robust. They

thought that the dread to negative outcomes and the cost of the self-control might

bring people to those behaviors.

Thanks to the lively discussion we showed above, the understanding about the

advance tax has progressed deeply. Furthermore, those results suggest the possibility

that simple nudges to taxpayers can reduce tax evasion, and that policymaker may

access to more efficient tax policies.

  11  
  

Now two kinds of systems, the advance tax system and the end-of-period tax

system, are used in a similar situation to correct the income tax. Past studies imply the

possibility that the people’s perception might change depending on the system, and

that it might affect their behavior of tax evasion. In this paper, we investigate a matter

that is still not clear, that is, which system encourages higher tax compliance. Of

course, comparing two systems used in different countries, different cultures or

different business environments is not easy and we cannot say which system is better.

However if there are tendencies in decision making that are characteristic of human

thinking, and if such tendencies affect the rate of tax evasion, our study might

contribute to make a more efficient tax policy.

  12  
  

Hypotheses and overview of the study

 
I. An illustrative theoretical model

 
The purpose of this section is to provide predictions for our experiment. We

apply prospect theory to a simple model of decision-making.

Now we assume that the individuals get the income W, and they are taxed t by

the government. When they file their tax declaration, the taxpayers report the income

X, and they pay the tax based on their declare income X. If they declare their actual

income (X=W) they will pay all of their imposition (tW). If they declare less than his

actual income (X<W), they could avoid the tax (t(W-X)). The tax authorities do not

know the taxpayers' actual income, so they should audit them and punish the tax

avoider by the penalty rate π for unpaid tax (t(W-X)). The probability of the audit is p

(0 ≤  p ≤  1)

§ W = Actual income

§ X =  reported income

§ t  =  Tax rate owed on declared income, 0 ≤  t ≤  1

§ p = Probability of audit, 0 ≤  p ≤  1

§ π = Fine rate for unpaid tax t(W-X) when taxpayer is caught by audit

First, we will model the individual's decision-making in advance tax. The

taxpayer pays the advance tax, D, by compulsion. When the subjects face the tax

declaration, they first have to choose whether they will avoid the tax or not. If the

taxpayers do not avoid the tax, their payoff is

𝑌!!" = 𝑝𝑎𝑦𝑜𝑓𝑓  𝑖𝑓  𝑛𝑜𝑡  𝑎𝑣𝑜𝑖𝑑𝑒𝑑   = 𝑡𝑊 − 𝐷 + (𝐷 − 𝑡𝑊)

  13  
  

When the individual declared an income X (< 𝑊) and they are not audited, the

taxpayer's payoff is

𝑌!!" = 𝑝𝑎𝑦𝑜𝑓𝑓  𝑖𝑓  𝑛𝑜𝑡  𝑎𝑢𝑑𝑖𝑡𝑒𝑑   =  𝑡𝑊 − 𝐷 + (𝐷 − 𝑡𝑋)

When the taxpayer is audited, their payoff is

𝑌!!" = 𝑝𝑎𝑦𝑜𝑓𝑓  𝑖𝑓    𝑎𝑢𝑑𝑖𝑡𝑒𝑑   =  𝑡𝑊 − 𝐷 + [𝐷 − 𝑡𝑋 − 𝑡(1 + 𝜋)(𝑊 − 𝑋)]

Under the prospect theory, the subjective value is decided depending on the

changes from the reference point (Kahneman and Tversky, 1979, Tversky and

Kahneman 1991,1992). However, as we showed above, what should be the valid

reference point has been widely discussed (Engström. et al, 2013).

Now we assume that a zero balance is the reference point for the taxpayers

when they file their tax declaration, because most of studies in this field employed it.

In the advance tax system, the reference point should be the income after the payment

of the advance tax and prior to their tax declaration, W – D. The changes in the

taxpayer’s net income therefore are

∆𝑌!!" = 𝐷 − 𝑡𝑊
∆𝑌!!" =  𝐷   −  𝑡𝑋
∆𝑌!!" =  𝐷   −  𝑡𝑋   − 𝑡 1 + 𝜋 𝑊 − 𝑋

Under the prospect theory, the value function v is used to explain the subjective value,

and each probability was weighted by the decision weight 𝜔, and this decision weight

would be different when the payoff is gain or loss (Kahneman and Tversky, 1979;

Tversky and Kahneman 1991,1992). From those, the taxpayer's value function in the

advance tax condition could be explained as below.

  14  
  

l When the taxpayer does not avoid the tax

𝑉!!" = 𝜔(1)𝜈(𝐷   −  𝑡𝑊) ∗ 𝜔(1)   =  1

l When the taxpayer avoid the tax

𝑉!! =  𝜔(1 − 𝑝)𝜈(𝐷   −  𝑡𝑋) + 𝜔𝑝𝜈  𝐷   −  𝑡𝑋 − 𝑡(1 + 𝜋)(𝑊 − 𝑋)

Next, we will model the individual's decision-making in the end-of-period

system. Taxpayers do not pay the advance tax, D. If the taxpayers do not avoid the tax,

their payoff is

𝑌!!" = 𝑝𝑎𝑦𝑜𝑓𝑓  𝑖𝑓  𝑛𝑜𝑡  𝑎𝑣𝑜𝑖𝑑𝑒𝑑   =  𝑊 − 𝑡𝑊

When the taxpayers avoid the tax and they are not audited, the taxpayers' payoff is

𝑌!!" = 𝑝𝑎𝑦𝑜𝑓𝑓  𝑖𝑓  𝑛𝑜𝑡  𝑎𝑢𝑑𝑖𝑡𝑒𝑑   =  𝑊 − 𝑡𝑋

When the taxpayers avoid the tax and they are audited,

𝑌!!" = 𝑝𝑎𝑦𝑜𝑓𝑓  𝑖𝑓    𝑎𝑢𝑑𝑖𝑡𝑒𝑑   =  𝑊 − 𝑡𝑋 − 𝑡(1 + 𝜋)(𝑊 − 𝑋)]

In the end-of-period system, the reference point should be the income prior to their

tax declaration, W. The changes in the taxpayers’ net income therefore are

∆𝑌!!" = −𝑡𝑊
∆𝑌!!" = −  𝑡𝑋
∆𝑌!!" = −  𝑡𝑋   − 𝑡 1 + 𝜋 𝑊 − 𝑋

The taxpayers' value function in the end-of-period system could be explained as

below.

l When the taxpayers did not avoid the tax

𝑉!!" = 𝜔(1)𝜈(−  𝑡𝑊) ∗ 𝜔(1)   =  1

l When the taxpayers avoided the tax

𝑉!! =  𝜔(1 − 𝑝)𝜈(  −  𝑡𝑋) + 𝜔𝑝𝜈  −  𝑡𝑋 − 𝑡(1 + 𝜋)(𝑊 − 𝑋)

  15  
  

II. Hypothesis

 
At first, we will assume the advance tax is set above the true tax liability,

𝐷 > 𝑡𝑊. In that case, it would be a similar situation with the taxpayer facing the

lottery showed below (Now we suppose that penalty rate  𝜋 is equal to the inverse

number of the probability of the audit (1/p), the expected values of those two choices

would be same for each other).

100%, 𝐷   −  𝑡𝑊   > 0

or

(1 − 𝑝)%, (𝐷 −  𝑡𝑋)  ;      𝑝%, 𝐷 −  𝑡𝑋 − 𝑡(1 + 𝜋)(𝑊 − 𝑋)

Under prospect theory, as people feel loss as more salient than gain, the shape

of the function is steeper in the negative than in the positive domain; losses loom

larger than corresponding gains; “loss aversion” (Kahneman and Tversky, 1979).

Namely, people have the tendency to avoid the loss. From this characteristic of the

decision-making, the individual is sure to avoid the choice that might make the loss,

and they prefer the choice that brings a certain gain.

Kahneman and Tversky tested a similar lottery in 1983. In their experiment,

the subject had to choose from following lotteries: A. a sure gain of $240, B. a 25%

chance to gain $1,000 or a 75% chance to gain nothing. From their report, 84% of

subjects chose the lottery A: they avoided the risky choice.

The past studies also showed that the overwithheld advance tax leads to very

high tax compliance (Robben et al.,1990; Schepanski and Kelsey, 1990;

  16  
  

Yaniv ,1998,1999; Schepanski and Shearer, 1995; Elffers and Hessing,1997). From

those, we could suspect the below hypothesis that

H1: Overwithheld advance tax induces a high level of compliance.

Second, assuming the advance tax is set below the true tax liability, 𝐷 < 𝑡𝑊.

In that case also, it would be a similar situation than which of the taxpayer facing the

lottery below.

100%, 𝐷   −  𝑡𝑊   < 0

or

(1 − 𝑝)%, (𝐷 −  𝑡𝑋)  ;      𝑝%, 𝐷 −  𝑡𝑋 − 𝑡(1 + 𝜋)(𝑊 − 𝑋)

In this lottery, the individuals face a choice of an assured loss or the choice of a

potential avoidance of the loss. Kahneman and Tversky (1979) also argued that the

value function is concave for gain and convex for losses. This characteristic means

that when an individual faces a potential loss, s/he would choose the more risky

choice (risk seeking).

Kahneman and Tversky tested a similar lottery in 1983. In their experiment,

the subject had to choose from following lotteries: A. a sure loss of $750, B. 25% a

chance to lose $1,000 or a 75% chance to lose nothing. From their report, 87% of

subjects choose the lottery B: they chose the risky choice. From those, we could

suspect the second hypothesis that

H2 : Underwithheld advance tax induces lower level of compliance than the

overwithheld advance tax.

  17  
  

Third, assuming that the individual does not pay the advance tax (in the end-

of-period condition). In that case, it would be a similar situation than which of the

taxpayer facing the lottery below.

100%, −  𝑡𝑊   < 0

or

(1 − 𝑝)%, (−  𝑡𝑋)  ;      𝑝%, −  𝑡𝑋 − 𝑡(1 + 𝜋)(𝑊 − 𝑋)

Same as the underwithheld advance tax situation, the individual faces the lottery of an

assured loss or the choice to potentially avoid the loss. Then, people prefer the risky

choice (i.e. people prefer the tax evasion), however, which one makes people more

risk seeking between the underwithheld condition in the advance tax system and in

the end-of-period system?

Please look at the graph1 (p.38). This graph shows two value functions: the

advance tax system (reference point is "W-D") and the end-of-period system

(reference point is "W"). We assumed that the individual has the same shape value

function in both tax payment systems. The value function of the advance tax

condition is shifted to the left by the amount of the advance tax D. By the difference

of those valuation functions, the subjective value of the advance tax condition is

smaller than the end-of-period condition. We suspect that the individual is more risk

seeking in the end-of-period condition than the advance tax condition. From those, we

could suspect the third hypothesis that

H3: Advance tax system, whether overwithheld or underwithheld condition, induces

higher level of tax compliance than the end-of-period system.

  18  
  

When the subject faces the tax declaration, he should make a two-step

decision. 1) First, whether he will evade the tax or not, and 2) second, if he decided

that he will evade the tax, how much he will evade. In above, we made the hypothesis

about the first step decision-making. Then, once the taxpayer decides to avoid the tax,

is the amount of the tax evasion the same for these two conditions?

Tversky and Kahneman (1974) argue a psychological heuristic that is called "

Anchoring". They explained this heuristics as “...people make estimates by starting

from an initial value that is adjusted to yield the final answer...” “Anchoring occurs

not only when the starting point is given to the subject, but also when the subject

bases his estimate on the result of some incomplete computation ” (p.185). For

instance when people estimate the percentage of African countries in the United

Nation, their estimation value is affected by the number that was given at first.

Taking into consideration this psychological heuristic, subjects’ perceptional

wealth might be anchored at the first wealth, which is the one just before the tax

declaration. If people avoid that their wealth decreases below that level (called "loss

aversion", Kahneman and Tversky, 1979), the taxpayer's decision-making about the

amount of tax evasion might be affected by the income level of which the tax would

be zero.

For the taxpayer in the advance tax condition, their additional tax payment is

𝐷   −  𝑡𝑋. If they try to avoid the additional tax as much as possible (𝐷   −  𝑡𝑋 → 0),
!
they report their income X will be close to ! . Therefore, the amount of tax avoidance

!
will be close to 𝑊   − ! . Besides, the taxpayer in the advance tax condition, their

paying tax is −  𝑡𝑋. If they try to avoid paying the tax as much as possible (−  𝑡𝑋 → 0),

  19  
  

they report their income X will be close to 0. Therefore, their amount of tax avoidance
!
will be close to W. Now 0 < W, 0 < W and 0 < t < 1, therefore, 𝑊   − !   <  𝑊. From

those, we could suspect the hypothesis that

H4: The amount of tax avoidance and the ratio of tax avoidance per income in the

advance tax condition is less than the end-of-period condition.

Additionally, we do not know anything about the long-term effect, which

came from the difference in the tax payment systems, because past studies did not

deal with this theme. Hence in this experiment, we will use a repeated game to

investigate how can a government use advance tax payments every year as a policy to

achieve higher compliance, or if taxpayers will adapt to such policy.

H5-0: The effect of advance tax to reduce the tax evasion has a long-term effect.

H5-1: The effect of advance tax to reduce the tax evasion has not a long term effect:

the taxpayer gets used to it and the evasion rate will be at the same level as paying

tax at once at the end of the taxation period.

  20  
  

Experimental design and procedures

The main focus of this experiment is to highlight that the difference in tax

compliance depends on the tax payment system. Furthermore we also study that, if

there is a difference between these two taxation methods, whether it affects the results

for more than during a few periods. To that end, we will use an experiment called the

tax game consisting of five periods. The dependent variable is the taxpayer's tax

compliance and the independent variables are the advance tax system or the end-of-

period system.

I. Tax game

In this game, the participants solved the tasks (Real effort task) and got an

income based on their achievement on the task. The task consisted in five kinds of

games. Each task was printed on one sheet of paper, with an example explaining the

task printed on the front, and the task itself printed on the back. The sheets were

distributed one by one for each participant. Before the beginning of the task, the

subjects received a flyer explaining the experiment and the tax policy parameters (i.e.,

fine, audit and tax rates). The experiment was conducted on groups of subjects which

size varied between 1 and 5 subjects.

We set the tax rate at t = 30%, the fine rate at π = 200% (i.e., participants have

to pay evaded taxes plus a penalty of 200% of unpaid taxes in the case of an audit).

Audits are assumed to be random and perfect. Audits occur with an announced

probability that is also fixed for all sessions at q = 1/3, and audits apply only to

current reported income, not to previous (or future) periods. (i.e. Appendix B)

  21  
  

The tax rate, fine rate, and audit rate were decided based on past experimental

studies about tax evasion (i.e. Appendix B). Under this condition, the expected values

of both choices are the same whether the taxpayer avoids the tax or not.

The income range that they could get from the game was 200 points to 400

points (after withhold tax, 110 points to 310 points). We assumed the tax is collected

for the development of economics and psychology.

The subjects were divided in 2 groups: (1) end-of-period system group, (2)

advance tax system group. The experimental treatments were run in a between-subject

design. To avoid the subjects’ perception of the inequality between them, we

conducted the experiment in a way that subjects from different groups do not have

contacts with each other.

In the end-of-period system, they were given an income that was consistent

with their number of correct answers, and this income was the pre-tax income. The

subjects got all their income at income period, then after income period, they had to

determine the amount of income they would have to self-report to the tax authorities.

They report pre-tax income.

In the advance tax system group, they were given an income that was

consistent with their number of correct answers, and that income is automatically

deducted of a withholding tax of 90 points. (it is across the board, same as the tax of

the middle score, 300 points, that they could get from the game). They report after-

withhold-tax income. All subjects in the advance tax system group were confronted

with both overwithheld and underwithheld situations, and the difficulty of the task

was manipulated by the time limit and the number of questions. In our expectation,

most of the subjects will have two or three times an overwithheld situation and also

  22  
  

two or three times an underwithheld situation during five games. For all games, the

audit was decided based on the result of "Rock, Paper, Scissors", if subjects choose

the same one as the experimenter, they would get the audit.

To avoid that some information affect the taxpayer's decision, we prohibited

the communication among the subjects. Besides, to keep the equality among the

subjects, we divided the experience in three sessions: one session is only for the

control group, another session is only for the loss domain group and the other session

is only for the gain domain group. Moreover, to avoid that the subjects get some

information about this experiment, we require that the subjects do not talk about this

experience outside of the experimental room.

As the subject's fortune could be negative by paying the penalty, we assume

that the subject had 500 points at the beginning of the game. To avoid the advance tax

system group's income from being negative, we assumed that the minimum wage was

90 points. Therefore, the subjects in the end-of-period system should report an income

over 90 points, and the subjects in the advance tax system should report an income

over 0 points.

The earned points are converted into Euros at the end of the experiment and

the exchange rate used was 100 points = 0.5 Euros. After the experiment, we asked

the subjects to donate their reward for the development of the economics and

psychology. However in this experiment, we noticed to the participants that this

experiment was a pilot experiment. We noticed that we would pass them some candy

instead of real money rewards, but we asked them to behave during this experiment as

if they were getting real money reward.

  23  
  

II. Risk attitude

After the tax game, we checked two kinds of subjects' attitude towards risk by

using the most frequently used risk attitude test: the risk aversion test that was

developed by Boschini et al (2014), and the loss aversion test that was developed by

Gächter, Johnson & Herrmann (2007).

The loss aversion test consisted of six choices. In these choices task

individuals decide for each of six lotteries whether they want to accept it (that is, play

it) or reject it (and receive nothing). In each lottery the winning price is fixed at 6 and

only the losing price varies (between 2 and 7). At the end of the experiment we

randomly selected one lottery for pay.

Risk aversion test consists of six choices between paired lotteries. In this task

individuals decide for each of six lotteries whether they get a sum that you obtain with

certainty, or flip a coin to win 100 €. In each lottery the prize that they get with

certainty varies (between 20 € and 75€). The experiment lasted about 10 minutes.

III. Participants

Our experiment was run with the students of the master 2 of economics and

psychology of Sorbonne University and Paris Descartes University, and the

acquaintances of the experimenter. Since we used the similar experiment in two

conation, we employed the between subject design to avoid the carryover effects.

To avoid any information bias and to explain this experimental game enough,

the subjects were divided into groups consisting of few members. Each participant

was not allowed to communicate with other participants. Clarification questions will

be addressed after participants complete reading the instructions and participate in a

practice exercise, before the game starts.

  24  
  

Result

I. Verification of hypothesis

In this section we will show our experimental result along with the number of

hypothesis. Before start to the analysis, we fix the income of the advance tax group

from the after withhold tax amount to the before withhold tax amount to compare

with the end-of-period system. The level of significance for all the analysis was set

at .05.

Table 1 (p. 36) shows the summary of tax evasion of each condition; mean and

standard deviation of age and the reported income over 5 periods. We employed ten

subjects for each treatment, total twenty subjects. We employed an independent-

samples t-test to determine if two sets of data are significantly different from each

other.

The mean age of subjects of the end-of-period group is 25.6 (SD = 2.84) and

the mean age of subjects of the advance tax age is 26.5 (SD = 3.37). There was not a

significant difference in the income for the end-of-period group (M=316, SD=80.5)

and advance tax group (M=339, SD=75.1) (t(98)= -1.478, p =.143). However, there

was a significant difference in the reported income for the end-of-period group

(M=237.2, SD=113.8) and advance tax group (M=317, SD=76.0) (t(98)= - 4.074, p

=.002).

About in the overwithheld advance tax system, we can observe that when the

tax was overwithheld, the tax evasion rate was 0% (tax compliance was 100%). From

this result our hypothesis 1 " Overwithheld advance tax induces a high level of

compliance." was supported.

  25  
  

Second, we will compare the underwithheld condition and the overwithheld

condition of the advance tax system. To determine whether there is a significant

difference between the two groups frequencies, we employed 𝑥 ! test (Chi-squared

test).

The tax evasion rate under the underwithheld condition (35.3%) was higher

than under the overwithheld condition (0%) (χ 2 =6.513, p = .000). From this result,

our hypothesis 2 " Underwithheld advance tax induces lower level of compliance than

the overwithheld advance tax " was also supported.

Third, we will compare the advance tax system and the end-of-period system.

The tax avoidance rate in the end-of-period group (50%) were higher than both

advance tax group the overwithheld condition (0.0%) (χ 2 =8.165, p =   .000) and the

underwithheld condition (35.3%) (χ2 =2.145, p =  .032).

Furthermore, we compare the rate of subjects who avoided every time (fully

evasion) and who did not avoid the tax every time (fully compliance), under the end-

of-period tax system and the advance tax system (Overwithheld and Underwithheld).

About the percentage of full evasion, there were more subjects who avoided

their tax every time under the end-of-period system (30%) than under the advance tax

system (0%) (χ 2 =5.940, p = .000). About the percentage of full compliance, there

were less subjects who did not avoid their tax every time under the end-of-period

system (10%) than under the advance tax system (60%), (χ 2 =7.413, p = .000).

From those results, we can observe that the advance tax system, even with an

underwithheld advance tax, induce higher tax compliance than the end-of-period

system. Therefore, our hypothesis 3 " Advance tax system, whether overwithheld or

  26  
  

underwithheld condition, induces higher level of tax compliance than the end-of-

period system " was supported.

Fourth, look at the right side of the table 1 (p.36): the average of the amount of

the tax avoidance, and the average of the ratio per income of the tax avoidance. This

averages ware calculated only among the subjects who avoid the tax.

The average amount of tax evasion is significantly higher in the end-of-period

system (M=157.600, SD= 6898.240) than the underwithheld advance tax condition

(M=91.67, SD= 2013.89) (t(35)=  2.504, p=.017). The average of ratio per income is

also significantly higher in the end-of-period system (M=41.480%, SD= 5.376) than

the underwithheld advance tax condition (M=18.6%, SD= .445) (t(30)=2.496, p=.018).

From those result, our hypothesis 4 " The amount of tax avoidance and the ratio of tax

avoidance per income in the advance tax condition is less than the end-of-period

condition." was supported.

Finally, we will focus on the long-term effect. From here we will employ two-

factor analysis of variance. The level of significance for all the analysis was

continually set at .05.

Graph 2 (p.38) shows the amount of the tax avoidance and the ratio of the tax

avoidance per income. At first, we will focus on the amount of avoidance. The two-

factor analysis of variance showed a significant main effect for the system of taxation

(end-of-period or advance), F(1, 90) = 13.3, p = .009 ; no significant main effect for

the period (F(4,90) = .993, p = .415), the interaction between period and type of

taxation system was not significant ( F(4, 90) = .551, p = .699).

  27  
  

Next we will focus on the tax avoidance ratio per income. The two-factor

analysis of variance showed a significant main effect for the system of taxation (end-

of-period or advance), (F(1,90) = 17.397, p = .000), no significant main effect for the

period, (F(4, 90) = .377, p = .825), the interaction between period and type of taxation

system was not significant, (F(4,90) = .164, p = .956).

We also analyze the long-term effect for the rate of the subjects who avoided

the tax. The two-factor analysis of variance showed significant main effect for the

system of taxation (end-of-period or advance), (F(1,90) = 7.348, p = .008), no

significant main effect for the period, (F(4, 90) = .391, p = .814), the interaction

between period and type of taxation system was not significant (F(4,90) = .609, p

= .657).

Those results were showed at the table 2 (p.37): The effect of the treatment

difference and the period. From those results, we can see that the amount of

avoidance, the ratio of avoidance per income and the rate of avoidance were affected

by the type of taxation system, and not affected by the period. In other words, the

effect of the taxation system did not decrease over the period. From this result, our

hypothesis 5-0 " The effect of advance tax to reduce the tax evasion has a long-term

effect" was supported, and hypothesis 5-1 " The effect of advance tax to reduce the tax

evasion has not a long term effect" was rejected.

  28  
  

II. Risk attitude and Tax evasion

Additionally to the verification of the hypothesis, we will report the relation

between the risk attitude and tax evasion behavior. Table 3 (p.37) showed the

correlation between the tax avoidance behavior and the risk attitude.

From those result, we could observe that the times of avoidance is correlated

with the individual's risk aversion (p=.009) and loss aversion (p= .022) in the end-of-

period system. Besides, the times of evasion is not correlated with both of risk attitude

(risk aversion, p = .649; loss aversion, p = .871) in the advance tax system.

The amount of avoided tax and the avoided tax ratio per income was checked

only for the subjects who avoided the tax.

The amount of avoided tax in the end-of-period is not correlated with both the

loss aversion (p = .107) and the risk aversion (p = .288). The amount of avoided tax in

the advance tax is also not correlated with both the loss aversion (p = .066) and the

risk aversion (p = .054), but those are correlated at the 10% level of significance.

The avoided tax ratio per income in the end-of-period is not correlated with

both the loss aversion (p = .962) and the risk aversion (p = .095), but the risk aversion

is correlated at the 10% level of significance. The avoided tax ratio per income in the

advance tax is correlated only with the loss aversion (p = .049). It is not correlated

with the risk aversion (p = .055), but the risk aversion is correlated at the 10% level of

significance. Those results showed at the table 3 (p.37).

From these results, we can observe that the decision whether the taxpayer

avoids the tax or not is correlated only in the end-of-period system. In the advance tax

  29  
  

system, the decision of the tax avoidance does not depend on the individual's risk

attitude.

However, once an individual decided to avoid the tax, the decision about how

much tax they avoid does not depend on the individual’s risk attitude in the end-of-

period system. Besides, in the advance system, it depended on the individual's risk

attitude (10% level of significance).

  30  
  

Discussion and conclusion

In this paper, we investigated the effects of two different income tax systems:

the advance tax system and the end-of period system, on individuals’ tax compliance.

Past empirical studies focused only on the differences between the overwithheld

condition and the underwithheld condition in the advance tax system. Therefore, the

difference between the advance tax system and the end-of-period system was not

clear, even though it has the possibility to lead to simple nudges in order to reduce tax

evasion.

In this paper, we applied prospect theory to the simple model of decision-

making. From this model, we made four hypotheses: 1) Overwithheld advance tax

induces a high level of compliance. 2) Underwithheld advance tax induces lower level

of compliance than the overwithheld advance tax. 3) Advance tax system, whether

overwithheld or underwithheld condition, induces higher level of tax compliance than

the end-of-period system. 4) The amount of tax avoidance and the ration of tax

avoidance per income in the advance tax system is less than the end-of-period system.

Additionally we investigated the long-term effect, which came from the difference of

the tax payment system, because past studies did not deal with this theme.

Our results from the comparison between overwithheld and underwithheld

situations supported past empirical studies. The overwithheld advance tax system

leads to a very high compliance rate. In our results, the compliance rate for the

overwithheld situation was 100% and it is indeed a very high tax compliance rate. The

underwithheld advance tax condition leads about 40% tax evasion. From this result

  31  
  

we can observe that overwithheld advance tax can induce higher tax compliance than

underwithheld advance tax. This result supported past studies in both experimental

and statistical fields.

As the main purpose of our paper, we highlighted the differences in tax

evasion rates between these two taxation systems. Our results showed that advance

tax system, not only the overwithholding condition but also underwithholding

condition, leads to a better tax compliance than the end-of-period system.

From this analysis, we showed that the advance tax system, even if set below

taxpayers' real tax liability, may substitute for costly detection effort in enhancing

compliance (Yaniv, 1998,1999)

Between these two-tax payment systems, there are also the differences in

decision-making about how much tax is avoided. The amount of avoidance and the

avoided ratio par income are smaller in the advance tax system, even though

underwithheld condition, than in the end-of-period system.

As explaining of this phenomenon, we suspect the psychological heuristics

called "anchoring" (Tversky and Kahneman, 1974)) and "loss aversion" (Tversky and

Kahneman, 1979). This is when the taxpayers anchored their wealth at its amount

just before the tax declaration, and they avoid decreasing their wealth amount below

that level. Therefore, the taxpayer in the end-of-period system has a tendency to evade

more tax than the taxpayer in the advance tax system.

We also researched the long-term effects of the advance tax system. Our

results showed that the amount of tax evasion, the evasion ratio per income and the

  32  
  

rate of subjects who avoid the tax were only affected by the difference in the taxation

system, and those were not affected by repetition. From this result, we found that,

even when used for multiple periods, the advance tax system keeps the same tax-

evasion-decreasing effect over time.

Even though we did not establish a proper hypothesis, we used this experiment

to research the relationship between individuals' risk attitude and tax evasion. We

investigated the relation between the times of evasion and the avoided amount per

evasion time, and the loss aversion and the risk aversion. From this analysis, we

showed that the decision whether the taxpayer avoids the tax or not is correlated with

their risk attitude when only they are in the end-of-period system. However, once

individuals decided to avoid the tax, the decision about how much tax they avoid is

not correlated with their tax attitude.

Although the past studies about the advance tax system showed the evidence

that the loss aversion might improve the taxation system, loss aversion itself had not

been directly tested (Luttmer and Singhal, 2014). Our study showed that the loss

aversion and the difference of the reference point between two-tax systems affected

the taxpayer's compliance.

Through this whole study and the result that taxpayer prefer the advance tax

system rather than the end-of-period system (Ayers, Kachelmeier and Robinson,

1999), we think that the advance tax system, especially in overwithholding conditions,

is a powerful and universal method to increase tax compliance. Even though tax

compliance correlates to a lot of other factors (for instance, laws or regulations), this

  33  
  

finding might lead the policymakers to a more effective taxation method than the

present system.

However in our study, since we fixed the tax rate, the audit rate or the penalty

rate, those effects on the two different taxation systems are not clear. Furthermore, we

have to consider the effects coming from the fact that we employed the students as

our subjects. According to the study by Kiechler and Maciejovsky (2001), the

reference point would be different depending on the habitual decision-making

framework. Therefore, if we would run this experiment for different professionals, for

instance the self-employed and the business entrepreneurs, the result would be

different from the present paper.

Furthermore, as a limitation of our study, we pointed out that there are factual

elements that we were not able to account for in our experiment. For example, in

advance tax countries, taxes are withheld every month on taxpayers' salaries:

therefore, annual tax payment itself is divided in twelve. In such system, the fact that

taxes are paid a little bit at a time over a long period of time (1 year) must induce a

different perception of tax payment that if such payment had to be made at once. The

impact of the payment method itself (i.e. monthly payment vs. yearly payment) may

also be accounted for in future research on the difference between tax payment

systems.

We also suggest, as another approaching method to develop this field, that

neuroeconomics is important to investigate the individual's decision-making.

Nowadays in most counties, the tax systems are often complex and non-transparent.

  34  
  

Therefore the study of the taxpayer's limits of their attention or their brain reaction

when taxes are changed might bring new findings to this field.

Additionally, the phenomenon that the advance tax leads to higher tax

compliance than the end-of period was observed by way of our experiment, but it has

not been demonstrated by the calculation perfectly yet. We think that formalizing the

individuals' tax behavior and clearly showing that the advance tax decreases tax

evasion is one of the most important studies in order to develop this field of research.

Finally, we hope that our study can contribute to the development of this field.

We also hope that the knowledge resulting from the study of this field will be used for

effective policy-making.

  35  
  
Table1. Summary of tax evasion of each condition
Tables and Graphs

% of fully % of fully Average of ratio per

N Age Income Reported Income Propotion tax aversion aversion compliance Average of amount income
M SD M SD M SD M SD M SD
End-of-period 10 25.6 2.84 316 80.5 237.2 * 113.8 50.0% * 30.0% 10.0% * 157.6 * 6898.2 41.5% * 5.4

Advance tax 10 26.5 3.37 339.0 75.1 317.0 76.0 24.0% 0.0% * 60.0% *
Underwithhold 386.8 22.4 354.4 * 59.5 68.0% 35.3% * 91.7 * 2013.9 18.6% * 0.4
overwithheld 228.6 25.7 228.6 * 25.7 28.0% 0.0% * - - - -
Just 300.0 0 300.0 0 4.0% 0.0% - - - -
* = significantly different (p<.05) between the advance tax system and the end-of-period system
 

36  
  

Table2: The effect of the treatment difference and the period (two-factor-ANOVA)

DF SS MS F p
Amount avoided
Treatment 1 80656 80656 13.29 0.000 **
Period 4 24114 6029 0.99 0.415
Treatment*Period 4 13374 3344 0.55 0.699
Error 90 546240 6069

Ratio per income

Treatment 1 0.90 0.90 17.40 0.000 **
Period 4 0.08 0.02 0.38 0.825
Treatment*Period 4 0.03 0.01 0.16 0.956
Error 90 4.65 0.05

Rate of evasion
Treatment 1 1.69 1.69 7.35 0.008 **
Period 4 0.36 0.09 0.39 0.814
Treatment*Period 4 0.56 0.14 0.61 0.657
Error 90 20.70 0.23
** p<0.05, * p<0.1

Table3. Correlation between Risk attitude and Tax evasion

Coef. S.E. t p
Times of aversion
End-of-period
Loss aversion 1.25 0.44 2.83 0.022 **
Risk aversion 1.67 0.49 3.39 0.009 **
Advance Tax
Loss aversion 0.25 0.53 0.47 0.649
Risk aversion -0.08 0.48 -0.17 0.871

Amount of avoid
End-of-period
Loss aversion 23.06 21.22 1.09 0.288
Risk aversion 3.21 1.92 1.68 0.107
Advance Tax
Loss aversion 41.18 19.98 2.06 0.066 *
Risk aversion 3.13 1.43 2.19 0.054 *

Ratio of avoid per income

End-of-period
Loss aversion 0.00 0.06 0.05 0.962
Risk aversion 0.01 0.01 1.74 0.095 *
Advance Tax
Loss aversion 0.12 0.05 2.24 0.049 **
Risk aversion 0.01 0.00 2.17 0.055 *
** p<0.05, * p<0.1

  37  
  

Graph1: Value functions of two different tax systems

Graph2: Amount and the ratio per income of the tax avoidance

  38  
  

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  43  
  

Appendix A. Tax evasion under Expected Utility Theory

I. Allingham and Sandmo Tax Compliance model

Allingham and Sandmo (1972) formalized the taxpayer behavior for under

uncertainty based on the Von Neumann-Morgenstern axioms. In his model, (hereafter

abbreviated A&S) there are 2 possibilities about the taxpayers' decision: 1)   He may

declare his actual income, 2) He may declare less than his actual income. If he de

choose later, his payoff depend on whether be audited or not.

Now, the individual get the income W, and they are taxed t % by the

government. When their declaration, the taxpayer declare the income X, and they pay

the tax based on their declare income X. If they declare their actual income, X=W, but

if they declare less than his actual income, X<W, they could avoid the tax W-X. The

tax authorities do not know the actual income, so they should do the audit and they

punish the tax avoider by the penalty rate π for undeclared amount (W-X). The

probability of the audit is p (0 ≤   p ≤   1), and in the A&S model, it is supposed that the

taxpayer know this probability. The tax authorities find the tax avoidance, they could

certainly know the taxpayer's actual income W. When the taxpayer is caught their tax

avoidance by the tax authorities, they should pay the penalty based on the fine rate

π(W-X). Now in the A&S model, it is supposed that t ≤ π, because if π is smaller than

t (π ≤ t), the penalty is smaller than the tax and it is not affect as the penalty for the tax

avoidance. Let me get this straight, the variables in the A&S model is as follow:

§ W = Actual income

§ X =  Declared income

§ t  =  Tax rate owed on declared income, 0 ≤  t ≤  1

§ p = Probability of audit, 0 ≤  p ≤  1

  44  
  

§ π = Fine rate for undeclared amount (W-X) when taxpayer is caught, t  ≤ π

When the taxpayer is not audited, the taxpayer's payoff is

𝑌 = 𝑝𝑎𝑦𝑜𝑓𝑓  𝑖𝑓  𝑛𝑜𝑡  𝑎𝑢𝑑𝑖𝑡𝑒𝑑   =  𝑊 − 𝑡𝑋

When the taxpayer is audited,

𝑍 = 𝑝𝑎𝑦𝑜𝑓𝑓  𝑖𝑓    𝑎𝑢𝑑𝑖𝑡𝑒𝑑   =  𝑊 − 𝑡𝑋 − 𝜋(𝑊 − 𝑋)

Now we assume that the individual is Risk aversion, the individual declare their

income in such a way as to maximize their utility.

𝐸𝑈 𝑋 =   1 − 𝑝 𝑈 𝑌 + 𝑝𝑈 𝑍 (1)

The first order condition for maximize the equation (1) can be written as follow.

𝐸𝑈′ 𝑋 =   −𝑡(1 − 𝑝)𝑈′(𝑌) + (𝜋 − 𝑡)𝑝𝑈′(𝑍)   =  0                                                            (2)

The second-order condition is satisfied by the assumption of concavity of the utility

function.

𝐷 ≡ 𝐸𝑈′′ 𝑋 =   −𝑡 ! (1 − 𝑝)𝑈′′(𝑌) + (𝜋 − 𝑡)! 𝑝𝑈′′(𝑍)   <  0                               (3)

In what follows, we will examine the impact of the increase in the tax rate t on the

declared income X.

First, differentiate (1) with respect to t.

𝑑𝑥 𝑡 1 − 𝑝 𝑈′ 𝑌 𝑅! 𝑌 − 𝑅! 𝑍 1 − 𝑝 𝑈′ 𝑌 + 𝑝𝑈′ 𝑍
  =     +                              (4)
𝑑𝑡 𝐷 𝐷

  45  
  

In this equation, 𝑅! (𝑌)  𝑎𝑛𝑑  𝑅! (𝑍) mean the Arrow–Pratt measure of absolute

risk-aversion(ARA),𝑅! (𝑌)   ≡   −𝑈′′ (𝑌) 𝑈′(𝑌) > 0,   𝑅! (𝑍)   ≡   −𝑈′′ (𝑍) 𝑈′(𝑍) > 0  .

If ARA is the decrease function, 𝑅! (𝑍)   >   𝑅! (𝑌). The second term of the equation

(4) is always negative, but the first term of (4) is transmutative; when the ARA is

decreasing, it will be positive, when ARA is constant, it will be 0, and when ARA is

increasing, it will be negative. Generically ARA is supposed to the decreasing

function, the first term of (4) is positive, then the sign of (4) could not be determined.

This result could be explained by the substitute effect and the income effect. If the

individual is caught by the tax avoidance, the fine rate is not increase in spite of

increasing the tax rate, the expected utility which come from tax avoidance would

increase and it rise the incentive of the tax avoidance, then individual decrease their

declared income X (the substitute effect). Besides, if their after-tax income decreases

by increase in the tax, when their ARA is the decreasing function, their attitude is

become more risk aversion, then they increase their declared income X (the income

effect). Which effect will domination the individual's behavior is depend on the slope

of the ARA, i.e. the first­‐order differentiation of the utility function.

Next, we will examine the impact of the increase in the fines rate π and the

audit rate p on the declared income X.

𝑑𝑥 𝑊 − 𝑋 𝑡 − π 𝑈′ 𝑍
  =     >  0
𝑑π 𝐷

𝑑𝑥 𝑡𝑈′ 𝑌 + 𝑡 − π 𝑈′ 𝑍
  =     >  0
𝑑p 𝐷

From those equation, we could observe that the increase in the fines rate π and

the audit rate p increase the declared income X.

  46  
  

II. The expansion of the A&S model - A&S/Y model-

Yitzhaki (1974) expanded the A&S model based on the actual scheme in the

United States (hereafter abbreviated A&S/Y model). The difference between A&S

model and the A&S/Y model is the penalty of the tax avoidance would be decided

based on not the undeclared income (W - X) but the concealment tax t(W - X). Now

the fine rate is defined as λ, then the expected utility of the individual is as follow.

𝐸𝑈 𝑋 =   1 − 𝑝 𝑈 𝑊 − 𝑡𝑋 + 𝑝𝑈 𝑊 − 𝑡𝑋 − λt(𝑊 − 𝑋)

According to the A&S/Y model, the increase in the tax rate t leads the increase

in the decaled income X under the decrease risk aversion.

III. Advance tax

We will show the advance tax under A&S/T theory here. Now the individual

pay the advance tax A. When the taxpayer is not audited, the taxpayer's payoff is

𝑌! = 𝑝𝑎𝑦𝑜𝑓𝑓  𝑖𝑓  𝑛𝑜𝑡  𝑎𝑢𝑑𝑖𝑡𝑒𝑑   =  𝑊 − 𝐴 − (𝑡𝑋 − 𝐴)

When the taxpayer is audited,

𝑍! = 𝑝𝑎𝑦𝑜𝑓𝑓  𝑖𝑓    𝑎𝑢𝑑𝑖𝑡𝑒𝑑   =  𝑊 − 𝐴 − (𝑡𝑋 − 𝐴) − 𝜋(𝑊 − 𝑋)

The expected utility is

𝐸𝑈 𝑋 =   1 − 𝑝 𝑈 𝑌! + 𝑝𝑈 𝑍!

The advance tax A is canceled out in this equation, so the advance tax pay no role in

the taxpayer's evasion decision.

  47  
  

Appendix B. Tax rate, Fine rate and Audit rate

We decided the tax rate, the fine rate and the audit rate based on past studies

about tax evasion. The A&S, A&S/T model assumes that taxpayers try to maximize

the outcome of a compliance decision by weighing the gain of successful evasion

against the risk of detection and punishment. Now this basic framework shows us the

possibility that the individual's compliance depends on the audit rate, tax rate and the

fine rate.

According to past empirical studies, both the negative and the positive effect

of the tax rate was reported. For instance, Clotfelter (1983), who analyzed American

taxpayers’ data from the 1969 TCMP, showed that lower compliance at high marginal

tax rates is reported. (Also Lang, Nöhrbaß, & Stahl;1997, Pommerehne & Weck-

Hannemann, 1996; Ali, Cecil, & Knoblett, 2001). Oppositely, Feinstein (1991) found

higher compliance at higher tax rates in aggregate data on American taxpayers from

the TCMP.

Besides in the experimental evidence, the mainstream view is that the tax rate

has a negative impact for the compliance rate. Alm, Jackson, & McKee (1992)

showed that when the fine rate is 200% and the tax rate increases from 10%, 30% to

50%, the compliance rate decreases from 38%, 33% to 20%. Friedland, Maital &

Rutenberg (1978) report the similar results. When the audit rate is 300% of the unpaid

tax and the tax rate increases from 25% to 50%, the compliance rate decreases from

43% to 19%. When the audit rate is 1500% of the unpaid tax and the tax rate increase

from 25% to 50%, the compliance rate decreases from 53% to 22%.

  48  
  

About the relation between the audit rate and the compliance rate, most

empirical studies showed the positive effect of audit probability on compliance

(Pommerehne & Weck-Hannemann, 1996; Ali, Cecil, & Knoblett , 2001).

Those results were supported by laboratory experiments. Alm, Sanchez, and

De Juan (1995) compared the audit rates of 5%, 30%, and 60% when the penalty rates

are 200% and 400% for the unpaid tax. In both conditions, the tax rate was 30%. They

found that the compliance rate is increasing correspondingly to the audit rate, from

7 % to 21 % and 55% when the penalty rate is 200% of the unpaid tax, and from 12 %

to 40 % and 70 % when the penalty rate is 400% of the unpaid tax. Bazart and Bonein

(2014) tested the compliance rate when the audit rate is 1/3 and the penalty rate is

350% of the unpaid tax, and their results show that the compliance rate was 46%.

The third parameter determining the expected value of being non-compliant

besides audit probabilities is the amount of fines. Simply put, high fine rates deter tax

evasion. We already showed above that Friedland, Maital and Rutenberg (1978)

reported that high fine rate increases the compliance rate.

Besides in our real life, the penalty rate was set to a lower level than in the

experimental situation. For instance in France, the penalty rate is maximum 80% of

the unpaid tax. We checked several countries' fine rate that was decided based on the

unpaid tax (France, USA, Australia, Japan and Canada), and the highest rate is 100%

and lowest rate is 40%.

Taking into consideration past studies, we made the experiment to aim that the

tax evasion rate is over 30%. Additionally, we considered the decision weight,

  49  
  

because the weight of probability affects the decision of tax evasion (Alm et al., 1992).

When Kahneman and Tversky proposed prospect theory in 1979, they argued two

points as key elements: 1) a value function that is concave for gain, convex for losses,

and steeper for losses than for gains, and 2) a nonlinear transformation of the

probability scale, which overweighs small probability and underweighs moderate and

high probability. In 1992, they showed the characteristics of the weighting function

by way of experiment. The shape of the weighting function was shown as below.

Figure 1: Weighting functions for gains (w+) and losses (w-) based on median

estimates of parameters

(Tversky and Kahneman, 1992)

  50  
  

According to this curve, the perceptional distortion of probability would be

minimum at the probability between 0.3 and 0.4. To minimize the impact of the

decision weight, we set the tax the audit rate is 1/3, and the penalty rate is 200% to be

the same expected values for the subjects whether they choose the tax evasion or not.

  51  
  

Appendix C. Experiment

I. Experiment instruction

i) End-of-period group

This experience consists of 5 kinds of tax games and a survey. The goal of this
tax game is earning the highest income you can, because your reward will be paid
based on the income that you got from this game. (Reward: 100 point=0.5euro, cutoff
under 10 sent)
In the tax game you will get an income based on your effort in the game. After
each game, you have to pay a tax, and we assume that now you have 500 point from
beginning. (This tax will be used for the development of the study of economics and
psychology). Tax rate is 30% and the tax is collected based on your report. We
never know how much income you got from the games, therefore you can keep more
income by reporting a lower income than your actual income to decrease your tax, but
we know that the minimum wage is 90. Therefore, you have to report an income over
90..
You can get a higher reward by reporting your income lower than your actual
income. However, we will check your income randomly. The probability of audit is
1/3. If you have reported a false income, you will have to pay an unpaid tax plus a
penalty. Penalty rate is 200% of unpaid taxes. (for instance, if you report your income
minus 100, you have to pay the penalty 100×30%(Tax)×200%=60). The audit will be
decided based on the result of "Rock, Paper, Scissors", if subjects choose the same
one as experimenter, they would get the audit.

ii) Advance tax group

This experience consists of 5 kinds of tax games and a survey. The goal of the
tax game is earning the highest income you can, because your reward will be paid
based on the income that you got from this game, and we assume that now you have
500 point from beginning. (Reward: 100 point=0.5euro, cutoff under 10 sent)
In the tax game you will get an income based on your effort, but that income is
reduced by a withholding tax of 90. Tax rate is 30%. After each tax game, your tax
will be adjusted based on your tax report. Please report your “after withheld tax

  52  
  

income” for this adjustment. If your actual tax is lower than the withheld tax, you will
get a refund. Oppositely, if your actual tax is higher than the withheld tax, you will
pay additional tax. (The tax will be used for the development of the study of
economics and psychology.)
We never know how much income you got from the games, therefore you can
keep more income by reporting a lower income than your actual income to decrease
your tax, but we know that the minimum wage is 0 reduced by a withholding tax of
90. Therefore, you have to report an income over 0.
You can get more reward by reporting your income lower than your actual
income. (If you report your income after withheld tax income is paid, you will not pay
the tax, furthermore you will get 90(withheld tax) - 90×30%(your actual tax) = 63
refund tax).
However, we will check your income randomly. The probability of audit is 1/3.
If you have reported the false income, you have to pay an unpaid tax plus a penalty.
Penalty rate is 200% of unpaid taxes (for instance, if you report your income minus
100, you have to pay the penalty 100×30%(Tax)×200%=60). The audit will be
decided based on the result of "Rock, Paper, Scissors", if subjects choose the same
one as experimenter, they would get the audit.

  53  
  

II. Examples of tax game

i) Graphical game
In this game, subjects must find the same shape as the one they were
previously shown. The time limit was 1minute. This game consisted of four games
that were similar with the game that is shown below. The subjects get an income
increasing with the number of correct answers: for 0 correct answers 200; for 1, 250;
for 2, 300; for 3, 350; for 4, 400.

ii) Rule of Numbers game

In this game, subject had to find the rule behind a sequence of numbers and
answer the number that replaces “?.” The time limit was 1 minute. This game
consisted of four games that were similar with the game that is shown below. The
subjects get an income increasing with the number of correct answers: for 0 correct
answers 200; for 1, 250; for 2, 300; for 3, 350; for 4, 400.

200 210 201 ? 202 208 (Answer. 209)

+10              -­‐9                +8            -­‐7                +6  

iii) Find the Lacking Number game

In this game, subjects were shown a figure made from numbers from 0 to 9,
but one number was lacking, and they had to answer the lacking number. The time
limit was 1minute. This game consisted of four games that were similar with the game
that is shown below. The subjects get an income increasing with the number of
correct answers: for 0 correct answers 200; for 1, 250; for 2, 300; for 3, 350; for 4,
400.

(Answer. 3)

  54  
  

iv) Math game

In this game, subject calculated the equation to fill the square. The time limit
was 1minute. This game consisted of twenty games that were similar with the game
that is shown below. The subjects get an income increasing with the number of
correct answers: for 0-6 correct answers 200; for 7-10, 250; for 11-13, 300; for 14-16,
350; for 17-20, 400.

7+︎⬜=13 (Answer. 6)

v) Word jumble

In this game, subject found the words hidden in the table below. We accepted
any word being a noun, a verb or an adjective, and we did not accept the names of
persons. The word should consist of over two contingent alphabets. We accepted
words aligned vertically, horizontally, and in diagonal. The subjects get an income
increasing with the number of correct answers: for 0-6 correct answers 200; for 7-10,
250; for 11-13, 300; for 14-16, 350; for over 17, 400.

Example. aunt

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