ProQuestDocuments 2023 01 03

The economics of tax compliance: What do we
know and where do we go?

Cuccia, Andrew D
ProQuest document link
ABSTRACT
Economic-based compliance research is useful in identifying underlying motives for taxpayer reporting. While
economic models alone may not predict taxpayer reporting decisions due to individual attitudes and biases,
economic incentives are important factors in understanding taxpayer behavior. Economic-based compliance
research should go through 3 related stages to be of maximum utility: 1. model development where internal
validity is verified, 2. empirical or experimental verification where construct validity is tested and the theory is
checked for completeness, and 3. integration of the model with other confounding or mitigating factors that may
affect external validity and predictive ability. The 3rd stage may be the most critical if research is to contribute to
the understanding of actual taxpayer behavior. Only by integrating approaches and directing examinations toward
small groups of taxpayers with homogenous incentives, both economic and attitudinal, can any contributions to
understanding actual decisions be made.
FULL TEXT

1.0 Introduction
Several authors have previously reviewed the tax compliance literature. Typically, these reviews have had rather
broad perspectives, enumerating various factors related to taxpayers' compliance decisions and reviewing, in
general, the methodologies employed (e.g., Jackson and Milliron [1986], Kinsey [1986], Long and Swingen [1991]).
However, much tax compliance research focuses specifically on economic incentives, examining issues such as
optimum audit and penalty rates, and using analytical and econometric methodologies. While much of this work
has been done by economists, accountants are increasing their use of economic-based models to examine
compliance issues and are beginning to make their own contributions to the literature.
There are a number of issues surrounding the usefulness and applicability of economic-based compliance
research. However, this line of research has received relatively little attention in previous reviews appearing in the
accounting literature.(1) This article examines more closely the development and general results of economic-
based compliance research. While general benefits and shortcomings of various models and methodologies are
discussed in the context of this development, this article does not address analytical modelling or econometric
issues in detail. Rather, it is intended to be a concise and purposeful view of the analytic and econometric
literature that may (1) help identify new avenues of research for accountants in which their knowledge of
institutional detail may be a major contribution and (2) encourage more inter-disciplinary work integrating
economic approaches with noneconomic models of decision-making typically examined by accounting
researchers.
2.0 THE DEVELOPMENT OF TAX COMPLIANCE RESEARCH
Taxpayer compliance has been primarily viewed from three theoretical perspectives: general deterrence theory,
economic deterrence models, and fiscal psychology. While these categories are not mutually exclusive and
classification of any one specific study may be difficult, this taxonomy aids discussion of the issues. Research
representing each of these perspectives is summarized below with particular emphasis placed on economic
approaches.
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2.1 Deterrence Theory
Much early work examining tax reporting was in the criminal justice literature. Accordingly, "noncompliance" was
implicitly defined as illegal tax evasion and deterrence theory provided the framework for examination. Deterrence
theory is concerned with the effects of sanctions and sanction threats on criminal or undesirable behavior. The
basic premise is that people choose to participate in activities that maximize their rewards and minimize their
costs. If sanctions are probable enough, and the costs severe enough to outweigh the rewards of an act, the act
will not be performed. Deterrence theory was used as a basis to examine many types of criminal behavior of which
tax evasion was merely one.
Early deterrence research centered around simple correlation analysis; that is, a negative correlation between
sanction threats and the threatened behavior was readily assumed by the general public and legal professionals as
well as researchers. However, little theory existed to link threats and behavior, and the underlying propositions of
the "theory" were questioned [Goode, 1972; Cohen, 1966]. As Tittle [1980, p. 1] stated, "The fundamental premise of
criminal justice is that people fear punishment and will obey the law if it provides a sufficient sanction threat." To
be characterized as a theory, however, more was needed than to be able to postulate, or even document,
relationships.
"The deterrence problem really consists of three parts: identifying sanctions or sanction threats in a meaningful
way, determining how much and what kind of effect they have on deviance, and specifying the mechanisms by
which the effect occurs" [Tittle, 1980, p. 5].
In spite of several theoretical and methodological shortcomings, findings in early deterrence research were
reasonably consistent. The certainty of sanctions being imposed, but not necessarily their severity, was inversely
related to the crime rate (e.g., Erickson and Gibbs [1976]; Tittle [1980]; Grasmick and Bryjak [1980]). Much of this
early work was done on a macro level, using crime statistics, arrest rates, prison records, etc., across legal
jurisdictions. Because of the methodologies involved, however, researchers were unable to rule out specific
competing hypotheses and were, therefore, unable to identify the mechanism through which any effects occurred.
For instance, while fear of sanctions was one possible explanation for a negative correlation between crime rates
and sanction levels, lower crime rates could also be due to individual offenders being incapacitated. In other
words, a lack of opportunity due to sanctions, rather than a fear of sanctions, might prevent the illegal act from
being performed [Erickson and Gibbs, 1976].
Refinements to the theory were made by focusing on micro-level data. For example, the importance of perceptions
in achieving the deterrent effect was recognized by examining individual rather than aggregate data [Grasmick and
Bryjak, 1980]. However, falsification of other competing hypotheses still remained a problem. For instance, while
the focus on perceptions rather than actual sanctions served to rule out incapacitation as the deterrent
mechanism, it suggested another: those individuals who feel most strongly about the behavior may also be those
individuals who perceive the sanctions to be strongest. Asking subjects about potential sanction threats and their
own behavior in a micro level study may merely uncover spurious correlations involving attitudes about the
studied behavior [Tittle, 1980].
The importance of perceptions also raised another important question regarding the causal ordering of the
perception and the undesired behavior. Paternoster, Saltzman, Waldo and Chiricos [1983] pointed out that most
studies had been cross-sectional analyses, finding correlations between perceptions of relevant sanctions and
past behavior. Since perceptions have been shown to be unstable over time [Minor and Marry, 1982] and to
potentially change with involvement in illegal behavior [Greenberg, 1981], perceptions of weak sanctions could be a
result of behavior rather than its cause. Using panel data, Paternoster, Saltzman, Waldo and Chiricos [1983] found
significant relationships between perceived sanction risk and past behavior, indicating an experiential effect.
However, they did not find the hypothesized relationship between perceived sanction risk and future behavior.
These findings cast considerable doubt on the deterrence research done up to that time and again emphasized the
need to identify the mechanism by which any deterrent effect might occur.
Other issues examined in deterrence research include the relative effects of formal versus informal sanctions

[Tittle, 1980; Paternoster, Saltzman, Waldo and Chiricos, 1983], the effects of socioeconomic and personality
variables [Tittle, 1980; Paternoster, Saltzman, Waldo and Chiricos, 1983], and the perceived fairness of the rules
being violated. However, many of these factors were ignored in early economic models of tax compliance.
Apparently, trey were assumed to be irrelevant, too difficult to capture or measure, or not under the direct control
of authorities.
2.2 Economic Deterrence
Tax compliance offered researchers a unique opportunity to solve some of the problems associated with general
deterrence research. For instance, while a basic utilitarian approach was at the heart of all deterrence research,
measurement of the sanction threat was often difficult. However, tax compliance conveniently allows for the
objective measurement of civil sanctions in monetary terms.
Not only does the tax setting allow for quantification of sanctions, but it can explicitly include another important
variable missing from most other deterrence research--the benefit derived from the deviant behavior. One could
argue that there would be no undesired behavior, even absent sanction threats, if there were no benefits to be
derived from the behavior. As Becker [1968] described it, crime can be looked a as an "industry" in which market
participants act to optimize their utility. A crime will be committed if the expected utility exceeds the utility which
could be derived from devoting energies elsewhere. In the tax setting, the costs and benefits of the crime, penalties
and tax savings, can be objectively identified and quantified, making the expected utility maximization paradigm
an obvious mechanism through which potential sanctions may operate. The enforcement problem itself, while not
explicitly viewed this way by early deterrence researchers, is also an economic problem in that it involves the
allocation of scarce resources so as to minimize losses to society. Optimal enforcement strategies, based on the
expected utility paradigm, were the focus of early economic deterrence research.
2.2.1 The Traditional Model
In the traditional economic view of tax compliance [Allingham and Sandmo, 1972; Becker, 1968; Srinivasan, 1973],
the evasion decision is modelled as a purely economic decision under uncertainty. A taxpayer chooses among
combinations of a riskless asset--reported income, and a risky asset--unreported income to maximize after-tax
income. The ultimate decision regarding the amount of the risky asset to purchase (i.e., the degree of
noncompliance) is determined solely by the probability of detection and the penalty structure, which are both
assumed to be exogenously determined, and the individualistic risk attitudes of the taxpayer. As the expected cost
of noncompliance rises, noncompliance is expected to decrease. Taxpayers are assumed to be rational and
conform to a set of von Neumann-Morgenstern [1944] utility functions.
Specifically, given a proportional tax and a penalty rate based on unreported income, the taxpayer will seek to
maximize the following:
E(u) = (1-p) U(w-tx)+ p U(w-tx-P(w-x))
where p = probability of detection, constant across x
w = true income
x = reported income
t = tax rate
P = penalty rate.
Given the focus of optimal audit and penalty structures, the primary issues examined were the effects of detection
probability and penalty rate on compliance. Consistent with deterrence theory, it was shown analytically that
noncompliance should decrease as both the probability of detection and the penalty increase [Allingham and
Sandmo, 1972; Srinivasan, 1973].(2)
The same model was subsequently used to examine other relationships which might aide in deterrence and
enforcement. For example, consider the relationship between personal income and compliance. Given decreasing
absolute risk aversion, an individual would choose to increase both the absolute and relative level of
noncompliance (i.e., investment in the risky asset) as income rises [Allingham and Sandmo, 1972]. This suggests
that a strategy of auditing taxpayers with the highest reported incomes will yield the most revenues for the taxing

authority. Of course, a progressive tax structure results in decreasing marginal utility of after-tax income, causing
taxpayers to act as if they were decreasingly risk-averse. Increasing income would, therefore, have the same effect
on compliance given a progressive tax, regardless of taxpayers' actual risk attitudes [Srinivasan, 1973].
As in early deterrence research, another interesting question was the relative effects of the size of the penalty and
the probability of detection. Both are under the control of the authorities, but vary considerably in the cost of their
implementation. Christiansen [1980] showed analytically that an increased fine accompanied by a reduction in
enforcement effort to keep the expected gain from evasion the same, could reduce evasion more than an
increased probability of detection and a lower fine. Practically, this result supports the use of a relatively low-cost
enforcement policy. Interestingly, this is contrary. to the results of earlier deterrence literature which generally
found that the certainty of detection was relatively more important than the severity of the sanction.(3)
Two other factors at the discretion of the authorities are the marginal tax rate and the structure of the tax function
(i.e., its progressivity). Allingham and Sandmo [1972] suggested that changes in the marginal tax rate will result in
offsetting effects. A higher tax rate will reduce after-tax income which, assuming decreasing relative risk aversion,
would tend to reduce evasion--the income effect. However, a higher rate would also make it more profitable to
evade taxes, resulting in increased evasion--the substitution effect. Overall then, the expected change in evasion
due to a change in the marginal tax rate would be ambiguous. Subsequent modelling, however, showed this result
to be highly dependent on the assumptions of the model regarding both the penalty and the risk preferences of the
taxpayer. For example, Yitzhaki [1974] showed that increases in the marginal tax rate should result in increased
compliance if penalties are a function of the unpaid tax rather than the unreported income. If the net penalty rose
along with the unpaid tax there would be no substitution effect, only a compliance-enhancing income effect.
Srinivasan [1973] demonstrated that the nature of the tax schedule itself may also affect compliance. Given that
the probability of detection and income are independent, he showed that a progressive tax function which yields
the same revenues as a proportional tax in the absence of noncompliance will yield less tax when noncompliance
is considered. This follows from the results of Allingham and Sandmo [1972] above. If the proportion of income
reported decreases at higher levels of income and a progressive tax raises revenues mostly from higher income
individuals, then a progressive tax should lose a greater part of total revenues to noncompliance.
While the relationship between marginal tax rates and compliance levels may be interesting theoretically, early
studies did not explicitly address how this relationship might be exploited. Tax rates are presumably set so as to
meet some revenue requirement (or equity concern) and are not likely be raised or lowered solely to affect
compliance. Koskela [1983], however, considered the potential compliance effects of a compensated change in tax
rates; that is, a change in the marginal tax rate accompanied by offsetting changes in transfer payments so as to
keep total tax revenues the same. This amounted to investigating an indirect change in the progressivity of the tax.
His results again depended on the nature of the penalty function. Increased tax rates (i.e., a more progressive tax)
result in decreased compliance when the penalty is based on the unreported income but increased compliance
when it is based on the underpaid tax. In the former case, there will be offsetting income and substitution effects
related to the tax rate change, similar to those found by Allingham and Sandmo [1972], but the compensating
transfer payment will eliminate the income effect, leaving only the compliance-inhibiting substitution effect. In the
latter case, the tax rate change will have no substitution effect, as shown by Yitzhaki [1974], and the income effect
will be even greater since the penalty, now based on a higher tax, will be increased.
A summary of the findings of these early studies is presented in the first two columns of Table 1.(Table 1 omitted)
These studies are all based on the same basic model and are often criticized on a number of grounds. First, they
make numerous, simplifying assumptions, such as the relative risk aversion of taxpayers, on which the results may
hinge. Incorrect assumptions may prevent findings from being generalizable to the real world. Second, they take
some parameters such as the probability of detection as exogenous when, in fact, they may be determined
endogenously, possibly making these early models misspecified. Third, given the assumption of rational taxpayers
with perfect knowledge, these studies ignore differences in the actual audit and penalty parameters and those
perceived by the taxpayer. If taxpayers do not use the objective parameters in their decisions, any models based

on these parameters will gain be misspecified [Birnbaum, 1973]. Finally, the model itself is relatively simplistic.
Since utility functions are individualistic, other nonpecuniary factors which may affect the taxpayer' s utility, and
therefore compliance, were originally ignored.
Some of these criticisms have been addressed by extending the basic economic model. Others may best be
viewed from alternative theories which are better equipped to handle the individualistic nature of the factors
involved.
2.2.2 Relaxing Simplifying Assumptions
2.2.2.1 Risk Attitudes
The predictions of analytic models are sensitive to the simplifying assumptions used in the analysis. While some
assumptions are made for convenience's sake and may not change the general findings, some, if incorrect, can
prevent any generalization of results. The importance of many of these assumptions may be examined directly.
For instance, it is was initially assumed that the taxpayer was decreasingly risk-averse. Beck and Jung [1989a]
relax this assumption and show that the findings of Yitzhaki [1974] regarding the effect of rising tax rates on
compliance no longer hold. Since the risk aversion assumption is necessary to achieve the compliance-enhancing
income effect, a risk-neutral taxpayer should not increase compliance in response to rising tax rates. Additionally,
if the penalty is based on. a percentage of the unpaid tax rather than the undeclared income, there will also be no
compliance-decreasing substitution effect. Tax rates would therefore have no effect on compliance, not because
the income and substitution effects offset each other as in the Allingham and Sandmo [1972] model, but because
there is neither an income nor substitution effect.
2.2.2.2 Uncertainty
Consistent with the origins of compliance research, most early models dealt strictly with tax evasion. They
assumed that taxpayers know their true income, tax liability, penalty rate and detection risk, and merely choose to
report fully or to evade based on these factors. However, for many taxpayers, the probability of detection is not the
only uncertainty they face.
Beck and Jung [1989a] were among the first to consider the effects of income uncertainty on the reporting
decision. This was done by modelling income as a random variable with a corresponding normal distribution.
Increased uncertainty was represented by imposing a mean-preserving spread over the distribution [Rothschild
and Stiglitz, 1970]. They found that increased income uncertainty will affect the amount of income reported, but
the direction of the effect will depend on the taxpayer's risk preference, as well as the initial impact of penalty and
audit rates. For risk-averse taxpayers, if the audit probability and penalty rate are already high enough that they are
reporting above the mean of their income distribution, an increase in income uncertainty will cause them to report
even greater income. The increased uncertainty increases the probability of true income greater than the original
report, and therefore, increases the expected marginal penalty.(4) However, increased uncertainty will reduce the
reported income of risk-neutral taxpayers at most reasonable penalty levels.
The addition of uncertainty to the traditional model does more than relax an assumption, however. The
introduction of income uncertainty suggests that the model is no longer restricted to the issue of intentional
noncompliance. It can also be adapted to address issues influencing the interpretation of the law by taxpayers, the
consequences of tax law complexity/ambiguity, and how that complexity/ambiguity might be exploited by the
taxing authority. For example, the results of Beck and Jung [1989a] suggest that, if taxpayers are risk-averse and
other enforcement parameters are sufficiently high, tax liability uncertainty increases total tax revenues. Similar
approaches have been used to examine different sources of uncertainty in the reporting environment. For example,
Scotchmer and Slemrod [1989], relying on somewhat different modelling assumptions, considered uncertainty due
to random assessments made by taxing authorities on examination rather than ignorance of the law itself.
Reinganum and Wilde [1988] modelled uncertainty in the tax authority's enforcement strategy as determined by
their audit costs. Alm, Jackson and McKee [1992b] examined uncertainty related to tax, audit and penalty rates.
These studies generally concluded that uncertainty in any form increases the amount of income reported by
taxpayers. The results of studies that have examined the effects of uncertainty on compliance are summarized in

Table 2.(Table 2 omitted)
2.2.3 Strategic models
Another criticism of early economic models was that they took some parameters as exogenous when, in fact, they
may be determined endogenously. For example, early models assumed that the audit rate was exogenously
determined and that the compliance decision was made in response to it. They did not allow for the possibility that
the audit rate might be dependent on compliance (i.e., on the initial report made by the taxpayer).(5)
Subsequently, two approaches--a principal-agent framework and a general equilibrium model--have been used to
explicitly model the interaction of taxpayers and the government. In the principal-agent framework, the taxing
authority pre-commits to an audit strategy in order to encourage compliance [Townsend, 1979; Baron and
Besanko, 1984; Border and Sobel, 1987; Reinganum and Wilde, 1985]. In a general equilibrium model, the taxing
authority and taxpayers simultaneously set audit rates and compliance levels in response to each other [Graetz,
Reinganum and Wilde, 1986; Reinganum and Wilde, 1986]. The predictions of these strategic models are
summarized in Table 3.(Table 3 omitted)
2.2.3.1 Agency Models
In agency models, the government (i.e., the principal) precommits to an audit strategy in order to encourage
maximum compliance by taxpayers. For instance, Reinganum and Wilde [1985] model the taxpayer as a risk-
neutral agent of the government who has private knowledge of his own income. The government, whose goal is to
maximize tax revenues net of audit costs, cannot observe actual income without costly investigation. Reinganum
and Wilde use this setting to compare a random audit strategy of the type implied in early models with a cutoff
audit strategy in which an agent triggers an audit by reporting below a certain level of income. They show that the
use of a cutoff strategy weakly dominates a random audit strategy because it will induce truthful reporting at the
least cost. In addition to the desirable effect on compliance, they argue that such a strategy would enhance
horizontal equity ex post over random auditing since those with equal incomes will be audited with equal certainty.
2.2.3.2 The General Equilibrium Approach

A general equilibrium model differs from the above agency framework in the order of play assumed. In a general
equilibrium model, the government sets audit rates in response to compliance levels rather than precommitting to
an audit strategy in advance. The tax filing itself represents merely a first round of information exchange between
the taxpayer and the taxing authority and the authority may respond by adjusting its audit strategy based on this
information. One example of such a model is that of Graetz, Reinganum and Wilde [1986]. As in many models of
this type, Graetz, Reinganum and Wilde simplify the setting to include taxpayers of only two types, high and low
income.(6) The solution to the game is a Nash equilibrium: a pair of strategies that are the best response to each
other and provide no incentive for either the taxing authority or the taxpayer to change strategies. The taxpayer
decides on the probability of falsely reporting a low income and the taxing authority decides on a probability of
auditing a taxpayer's report of low income.
As intuition might suggest, the most basic finding of the simpler models is supported: the level of fines is still
positively related to compliance. The interactive framework, however, leads to different conclusions regarding the
effects of tax rates and the nature of the tax function on compliance. Graetz, Reinganum and Wilde [1986] show
that in a progressive tax system, increases in the higher tax rates (i.e., increased progressivity) result in increased
compliance. While there is still the familiar compliance-inhibiting substitution effect, auditing also yields an
increased marginal gain to the taxing authority. Graetz, Reinganum and Wilde predict that this latter effect will
dominate. Note that the result is consistent with the earlier findings of Koskela [1983]. However, Koskela's
conclusions are based on the assumptions of decreasingly risk-averse taxpayers and a penalty based on unpaid
tax. The predictions of Graetz Reinganum and Wilde follow from the increased marginal gains to auditing and are
not dependent on taxpayer's risk preferences.
Reinganum and Wilde [1986] also incorporate the taxing authority as a strategic actor in a game, investigating the
effects of the taxpayer's true income on compliance. They show that within a given audit class (i.e., where all

taxpayers are otherwise indistinguishable) reporting lower income results in a higher probability of audit as the
expected marginal benefit of auditing increases. According to Reinganum and Wilde, unreported income should
decline as true income rises unless risk aversion drops precipitously. As they point out, this is unlikely within single
audit classes. This result suggests that a statutory linear tax function results in an ex post regressive tax after
considering the difference in audit coverage.(7) Alternately, across audit classes, those with equal true incomes
but greater earnings potential will underreport greater amounts of income and therefore merit greater audit
resources. Note the effect of income on compliance is opposite that predicted by the earlier, non-strategic models
(Table 1 versus Table 3).
Finally, Beck and Jung [1989b] and Beck, Davis and Jung [1492] extend the work of Graetz, Reinganum and Wilde
[1986] and Reinganum and Wilde [1985, 1986] by introducing tax liability uncertainty into the interactive
framework. While the negative effect of uncertainty on aggressiveness found in the fixed audit model is still
present, they show that the effect is enhanced due to the increased benefits of auditing in the strategic setting
(predicted by Graetz, Reinganum and Wilde) and results in even higher reported income.
2.2.4 The Use of Professional Preparers
Recently, the effect of professional preparers on taxpayers' reported income has received increased attention.
Professional preparers serve various functions in the compliance process, with each of those functions having
potential effects on reported income.
One function of professional preparers is to reduce the income uncertainty faced by taxpayers. Like other factors,
income uncertainty was assumed to be exogenous in early models. However, incorporating the preparer into the
model allows the taxpayer to reduce this uncertainty by acquiring costly information. Beck, Davis and Jung [1994]
consider a preparer who, due to his or her expertise, can totally resolve a taxpayer's income uncertainty. Starting
with the model of Beck and Jung [1989b], they show that only taxpayers who are most unsure about their income
will be motivated to hire preparers. A preparer offers both tax savings to those who might have incorrectly reported
a high income, and penalty savings to those who might have reported too low. However, taxpayers who believe
more strongly that their income is high (low) will not hire a preparer because the fee paid will not justify the low
expected tax (penalty) savings that might be generated. The availability of preparers is expected to have no net
effect on reported income since the tax revenue gained from those who would have reported lower without the
preparer will be offset by the revenue lost from those who learn their liability is less than expected. However, total
revenues may decrease since those who would have reported low and incurred a penalty are now prevented from
doing so.
The environment modeled by Beck, Davis and Jung [1994] is extremely simplified, allowing no legal ambiguity. All
income uncertainty is assumed to arise due to taxpayers' lack of expertise and can be resolved completely by the
preparer. The preparer cannot cheat, or otherwise report strategically. In effect, the preparer is one form of costly
information acquisition. Other forms for which the results would also apply include investment of the taxpayer's
own time and effort in research. Klepper and Nagin [1989a] and Klepper, Mazur and Nagin [1991] advance another
model of the preparer which expands the services provided by preparers and explicitly deals with ambiguity as well
as uncertainty. In this model, the preparer is similar to an investment advisor who informs taxpayers of possible
risk-return combinations available to them, except that the use of a preparer may limit the availability of certain
noncompliant options which would otherwise be available. Taxpayers are endowed with two types of income--
ambiguous and unambiguous. They face penalties for underreporting income, with penalties related to
underreported unambiguous income being greater as there is greater culpability associated with unambiguous
income. Since ambiguous items are open to different interpretations, underreporting of these items may be due to
honest differences of opinion and are not subject to as severe a penalty.
Preparers in this model serve to reduce the severity of penalties to which taxpayers are subject and therefore
increase their after-tax income. However, preparers themselves are subject to penalties and must be compensated
by taxpayers for reporting risky positions. It is assumed that the reduction in expected taxpayer penalties achieved
by engaging a preparer is greater than the compensation paid to preparers for incurring the increased risk.

However, preparers cannot reduce the penalties associated with unambiguous items since they are not subject to
varying interpretations. Preparers, then, can be expected to enhance compliance for unambiguous items but to
exploit ambiguous aspects of the law.
Klepper and his colleagues empirically test their model by constructing a measure of ambiguity, based on the
number of related revenue rulings issued, for each line item on the tax return. Using Taxpayer Compliance
Measurement Program (TCMP) data, they find that differences between the voluntary reporting percentages (i.e.,
the percentage of taxes paid to taxes owed determined at audit) of self-prepared and paid-preparer returns are
related to the relative ambiguity of each line item with preparers reporting relatively lower income as ambiguity
increases. This methodology cannot, however, account for any self-selection bias. Differences in the voluntary
reporting percentages across preparation modes may be due to inherent differences in ambiguity or complexity
rather than the use of preparers.
Scotchmer [1989] also allows for the possibility of unresolvable ambiguity. In her model, the taxpayer is unsure of
his or her true tax liability and has the option of "guessing" or hiring an advisor. This decision is based on the
relative ex ante expected utility of each option. Similar to Beck, Davis and Jung [1994], she shows that if taxpayers
are reporting at or above the mean of their income distribution, retaining a preparer will result in lower total
revenues collected since penalties are asymmetric (i.e., penalties are assessed for underpayments but there are no
"rewards" paid to taxpayers for overpayments). Due to legal responsibilities and professional codes of ethics,
preparers do not cheat but are "prevented from taking entirely riskless tax positions" by their "duty to act in the
interest of the client" [Scotchmer, 1989, p. 190]. Preparers balance their legal obligations with market forces by
permitting underreporting but demanding compensation for bearing the risk of penalties. One effect of preparer
penalties, then, is to discourage aggressiveness by those taxpayers retaining preparers by increasing taxpayers'
compound penalty (their own penalty plus the additional compensation required by preparers).
Finally, Reinganum and Wilde [1991] suggest that preparers may have an effect on reported income absent any
informational aspects of their services. In their model, taxpayers' costs of preparing their returns, and potential
costs in addition to fines and penalties if the return is audited, are explicitly considered. The preparer provides
representation for taxpayers before the IRS and therefore offers the taxpayer some protection against audit costs.
The preparer seeks to maximize net profits which are based on the fee charged to clients, the costs of preparation,
and the potential costs incurred if a return is audited. The amount of income reported when a preparer is hired
depends on both the level of preparer penalties and the level of protection provided by preparers. Because the
amount reported by the taxpayer decreases with a decrease in the perceived costs of an audit and the use of a
preparer can shield the taxpayer from these costs, using a preparer is expected to result in less income being
reported if preparer penalties are low. However, as long as there are preparer penalties and those penalties are
included in the taxing authority's objective function, the taxing authority will devote more audit effort to paid-
preparer returns. High preparer penalties will, therefore, reduce the potential benefits of audit protection. If
penalties are high enough, compliance may increase with the use of a preparer. The predictions of these models
are summarized in Table 4.(Table 4 omitted)
2.3 Testing the Models
The preceding discussion shows that many of the problems regarding the assumptions made in early analytical
models and their generalizabilty could be addressed by expanding the models. However, empirical methods must
be used to address the external validity of the assumptions and of the models themselves. The models described
above have been tested primarily using one of two methods: econometric analysis of archival data and laboratory
experiments.
2.3.1 Econometric Studies
Recall that several researchers demonstrated analytically that tax compliance increased with both the probability
of detection and penalty rates. Witte and Woodbury [1985] tested these findings empirically. Recognizing that
different types of taxpayers may differ significantly in compliance behavior, Witte and Woodbury estimated seven
separate regression models, one for each audit class. Using voluntary compliance percentages from the TCMP,

Witte and Woodbury found that the actual audit rate was positively related to compliance. As in earlier deterrence
work, but contrary to Christiansen [1989], the probability of civil penalties (i.e., the strength of the penalty) had no
effect.
Clotfelter [1983] empirically examined the effects of marginal tax rates and income levels on compliance. Using
1969 TCMP data to estimate models for each reporting class and return type, he found that both income and tax
rates were positively related to noncompliance. The results concerning income levels are consistent with the
models of Allingham and Sandmo [1972] and Srinivasan [1973]. However, the findings concerning the tax rate are
inconsistent with both the traditional models of Yitzhaki [1974] and Christiansen [1980] as well as the latter
strategic models of Graetz, Reinganum and Wilde [1986] and Beck and Jung [1989b].(8)
Econometric studies, however, are at most merely tests of correlation. While analytical models imply causation,
such cannot be inferred from econometric analyses. For example, early analytical models assumed that the audit
rate was exogenously determined and that the compliance decision was made in response to it. However, such a
relationship found in an econometric test cannot distinguish between higher audit rates resulting in higher
reported incomes or higher reported incomes causing a higher audit rate. The mutual dependence of two factors
on each other may result in potential misspecification of the model, making parameter estimation, as well as
interpretation of the tests, problematic.
Witte and Woodbury [1985] recognized this potential "simultaneity bias." The segregation of their sample into
several audit classes before testing the effect of audit rates on compliance was an attempt to mitigate the
problem. Clotfelter [1983] also examined audit classes separately, leaving audit rates out of his model completely.
While the approaches of both Witte and Woodbury, and Clotfelter, recognized the problem, neither could allow for
the simultaneous determination of both audit rates and compliance decisions.
Dubin and Wilde [1988] and Dubin, Graetz and Wilde [1987] used an instrumental variables approach to test for the
endogeneity of audit rates. Regressing audit probabilities on the IRS regional budgets and then including the
predicted value of audit probability in their regressions, Dubin and his colleagues showed that audit rates were
indeed endogenous in at least five of the seven audit categories examined. Allowing for endogeneity also
corrected what appeared to be a compliance-inhibiting effect of audits in a sixth audit class. While a deterrent
effect of audits on noncompliance was still found, the probability of audit was actually negatively related to
compliance due to the incentive of the IRS to audit reports with the greatest expected return. Alm, Bahl and Murray
[1993] also show that the Jamaican audit selection process was a strategic process, positively related to the level
of income reported and taxpayers' marginal tax rates.
Econometric tests of compliance have several other shortcomings. Cross-sectional studies cannot control for the
multicollinearity which occurs in archival data. For example, differences in marginal tax rates across taxpayers are
unavoidably related to differences in income. Inclusion of both factors in any model creates multicollinearity
problems which make estimates of their importance unreliable while omitting one factor results in biased
estimates. This may have been a problem in the failure of Clotfelter [1983] to support the predictions of both
strategic and non-strategic models regarding the effects of tax rates on compliance. Time-series analyses lack the
mechanism to control for other changes which may occur simultaneously with the factors of interest. For example,
a change in tax rates may also be accompanied by changes in tax law complexity. Changes in compliance levels,
therefore, cannot be attributed to either.
The data used in many econometric studies also suffer from various shortcomings. For instance, much work is
done using TCMP data. While these data offer researchers a rich and detailed opportunity for examining actual
noncompliance, they do have many problems which have been addressed often in the literature (e.g., Fischer,
Wartick and Mark [1992]; Long and Swingen [1991]; Alm [1991]) including the following: (1) TCMP audits cannot
detect the unreported income of non-filers and do not uncover all unreported income of those audited--a problem
of omitted and biased observations; (2) the data cannot detect cases of noncompliance which were deterred--a
problem of a censored dependent variable; (3) the noncompliance uncovered in a TCMP audit is the result of an
agent's report which can be overturned on appeal--a problem of biased dependent variables; and (4) TCMP audits

are unable to distinguish between intentional and unintentional types of noncompliance--a problem of noisy
dependent variables. While an error or oversight on the taxpayers' part may meet the technical definition of
noncompliance, these are probably not the types of reporting decisions researchers such as Witte and Woodbury
[1985] and Clotfelter [1983] are attempting to examine.
2.3.2 Laboratory Experiments
Controlled laboratory experiments can mitigate many of the problems listed above. For example, by having
subjects face hypothetical reporting decisions and using fully-crossed experimental designs, the correlation
between tax rates and income present in archival data can be avoided. Causation, which cannot be inferred from
correlation studies, can be attributed to specific factors by introducing manipulations into otherwise controlled
environments. Finally, socio-economic factors and taxpayer uncertainty, both which may affect compliance and
confound results of econometric studies, can either be controlled by capturing them in a post-experimental
instrument and including them in the analysis (e.g., gender, age, attitudes regarding tax law fairness) or by
experimentally manipulating them (e.g., risk preferences, audit and penalty rates).
Friedland, Maital and Rutenberg [1978] were among the first to use such an approach to examine relationships
suggested by earlier economic models. They examined the effects of tax rates and penalty levels on compliance.
Subjects were assigned an amount of income and asked to file a tax report for a series of experimental periods.
The tax and penalty rates were manipulated so that each subject faced all possible combinations. At the end of the
experiment, all subjects received a small monetary reward in proportion to their final after-tax income. Consistent
with the models of Allingham and Sandmo [1972] and Yitzhaki [1974], penalty rates were positively related to
compliance. However, contrary to those same models, tax rates were negatively related to compliance.
Friedland, Maital and Rutenberg [1978] also examined the relative effects of audit probability and penalty rates.
When manipulating the penalty, an offsetting adjustment of the probability of detection kept the cost of
compliance constant. The positive effect of penalty size on compliance, therefore, also infers that the size of the
penalty was more important than the probability of detection, consistent with the analytical results of Christiansen
[1980]. In the context of the laboratory experiment, Friedland, Maital and Rutenberg were also able to capture via a
debriefing questionnaire, and therefore control any effects of, subject demographics such as gender and relative
risk preferences.
Friedland [1982] used a laboratory setting to examine the effects of uncertainty regarding audit and penalty rates.
Using the same method as Friedland, Maital and Rutenberg [1978], he found that uncertainty surrounding audit
rates enhanced the deterrent power of both low probability audits and low levels of penalties.(9) However,
uncertainty regarding penalty rates had no effect on compliance. Contrary to Friedland, Maital and Rutenberg,
Friedland found that the probability of audits was more important than the level of sanctions in deterring cheating.
Finally, Klepper and Nagin [1989b] used a laboratory setting to examine the effects of detection probability on
noncompliance, but did not manipulate detection probability directly. Instead, in a joint test of (1) factors which
affect perceptions of detection risk and (2) the effect of perceived detection risk on compliance, they manipulated
detection risk indirectly by controlling both the absolute amount of the item in question as well as its percentage
of subjects' total income in a hypothetical reporting scenario. They showed that the perceived detection risk of
their student-subjects was positively related to both the total and percentage noncompliance and that perceived
detection risk in turn affected subjects' willingness to evade. In addition to providing support for the compliance-
enhancing effect of detection rates, the results suggest that audit rates (or at least taxpayers' perceptions of audit
rates) are in fact endogenous. Consequently, simple manipulations of audit rates in experimental studies may not
provide the type of control over the construct implied by that methodology.
While the laboratory can solve several problems inherent in econometric studies, it has several shortcomings of its
own. The relatively weak costs and rewards existing in the laboratory, as well as the unavoidable artificiality of the
setting, raise doubt about the external validity of laboratory studies. Also, attitudinal factors and/or social norms
may mask the effects of economic factors an subjects' reporting decisions. To avoid this problem, subjects in
Friedland [1982] and Friedland, Maital and Rutenberg [1978] were explicitly told to "maximize your net income." As

a result, only 18 of 240 reports given by subjects in Friedland, Maital and Rutenberg [1978] were honest,
suggesting the possibility of demand effects and raising doubt about the generalizability of the results.
2.2.4.3 Experimental Economics
While attitudinal factors may have affected subjects' responses to economic incentives in the above studies, much
subsequent research has been designed to isolate economic incentives at the expense of external validity. The
goal of experimental economics is to isolate and examine only the underlying economic relationships and
incentives in a controlled environment. Economic incentives are designed to be great enough to dominate
subjects' decisions. While the economic relationships of the taxpaying environment are highlighted, the context of
the decision is masked to prevent social norms from detracting from the salience of monetary payoffs.(10) The
methodology offers researchers what real world settings cannot: the opportunity to test the underlying
assumptions of an economic model in a sterile setting (see Davis and Swenson [1988] and Alm [1991];for
descriptions of experimental economics methods and their applicability to tax policy research). Experimental
economics allows the creation of an environment in a laboratory with specific and definite institutional parameters
to test the predictions of an analytical model. Attitudes and biases normally associated with tax reporting are
hopefully avoided and the economic incentives and their effects isolated.
In the broadest sense, any experiment involving economic incentives for subjects could be characterized as
experimental economics. However, it is questionable whether many early studies [e.g., Friedland, 1978; Friedland,
Maital and Rutenberg, 1982; Spicer and Thomas, 1982 successfully captured economic incentives while at the
same time eliminating other competing influences. A recent example of experimental economics applied to tax
compliance is Alm, Jackson and McKee's [1992a] test of the effects of tax, audit, and penalty rates, and income, on
compliance. As is typical in such studies, student subjects received experimental income and decided how much
income to report. They faced announced random audit probabilities and paid any reported tax liability, detected
underpaid taxes, and applicable penalties. Any income remaining at the end of the experiment was redeemed in
cash. Groups of subjects repeated this scenario for several periods until detectable strategies were formed. Into
this setting, various manipulations were introduced, including changes in tax rate, audit rate, penalty rate, and
income. Consistent with the predictions of analytical models and with the econometric work of Witte and
Woodbury [1985], audit rates were found to significantly increase the compliance rate. Similarly, while only
marginally significant, compliance was positively related to the penalty rate. Contrary to the analytical models,
however, increased income (tax rates) was found to increase (decrease) compliance. The former (latter) result is
consistent with econometric results of Witte and Woodbury [1985] (Clotfelter [1983]).
Both these latter results point out potential problems in using laboratory experiments to examine economic
incentives. One concern is the construct validity of experimental manipulations. For example, analytical models
which predict negative (positive) effects of income (tax rates) on compliance rely on the income effect. This effect
stems from the assumption of decreasing risk aversion, or progressive taxation, which will cause individuals to act
as if they were decreasingly risk-averse. However, in Alm, Jackson and McKee's [1992a] experimental sessions
described above, subjects based their decisions on income levels which varied between $2-$3. While these
payments may have met two of the requirements of economic incentives in experimental economics (i.e., salience
and dominance within the laboratory setting), it is questionable whether such a narrow range could capture the
income-variance of real taxpayers which might lead them to respond to the compliance decision differently.
Correspondingly, subjects' experimental reporting decisions may be determined more by their actual income and
wealth levels and corresponding risk preferences brought with them to the experiment than by the experimental
manipulations. Alternately, attending to experimental manipulations may result in incentives inconsistent with
those intended in the laboratory as well as those existing in the real world. For example, the relatively low levels of
experimental payoffs may have resulted in some degree of game-playing by the subjects in the Alm, Jackson and
McKee study and caused them to act as if they were risk-seeking in the experiment, partially explaining the
unexpected results.
Alm, Jackson and McKee's [1992a] findings of a negative effect of tax rates on compliance are also inconsistent

with those of Beck and Jung [1989a] who relax the assumption of risk aversion. Recall Beck and Jung
hypothesized that tax rates should have no effect on compliance when taxpayers are risk-neutral. While Alm,
Jackson and McKee [1992a] did not explicitly examine the risk preferences of their subjects, Beck, Davis and Jung
[1991] controlled their subjects' risk preferences via the rules determining their compensation (Berg, Daley,
Dickhaut and O'Brien [1986]) to explicitly test the moderating effects of risk preferences, as well as tax-liability
uncertainty, on tax, audit and penalty rates as predicted by Beck and Jung [1989a]. The model's predictions of
positive effects of audit and penalty rates on reported income were generally supported, as was the prediction of a
positive (no) effect of tax rates on risk-averse (neutral) taxpayers. Also as predicted, the effect of increasing
uncertainty depended on other factors. For risk-averse taxpayers already reporting above (below) the mean of their
income distribution because of a high (low) tax rate, increased uncertainty led to higher (lower) reports. For risk-
neutral taxpayers, increased uncertainty had no effect on reported income except when audit rates were extremely
high.
Finally, Beck, Davis and Jung [1992] tested the effects of tax rates and income uncertainty on reported income in a
strategic setting. Strategic auditing was operationalized by employing a computer program to make audit
investigation decisions based on the enforcement agency's audit costs (disclosed to subjects), the tax rate, and
amount of income uncertainty. They found that, as predicted by Beck and lung [1989b], both tax rates and income
uncertainty were positively correlated with the income reported by subjects.
2.4 Fiscal Psychology
A great deal of attention has also been given to the effects of non-economic factors such as demographics,
attitudes, and perceptions on compliance. Various demographic factors (e.g., age, gender), perceptions of the
legality or morality of evasion, effects of interpersonal sanctions, and perceptions of peer compliance and fairness
of the tax laws have been examined explicitly as important factors in the compliance decision. Given the focus on
factors not observable in macro-level archival data, fiscal psychology research usually adopts a survey or
laboratory methodology. Jackson and Milliron [1986], Kinsey [1986] and others provide extensive reviews of this
research. Some general observations are made here.
While fiscal psychology offers a different perspective of compliance, several methodological concerns must be
considered. As discussed above, since attitudes and beliefs are not observable in archival data, a significant
portion of this research relies on either self-reports of compliance, or compliance intentions. The reliability of self-
reports is questionable for several reasons, including respondents' potential lack of self-insight, simple memory
lapses, and perhaps most importantly, the lack of any consequences related to the decision of interest. It has been
suggested that evaders may not confess and that compliers may actually boast about actions not taken. For
instance, Elffers, Weigel and Hessing [1987] were able to identify a group of actual evaders through the taxing
authorities in The Netherlands. They found that one group of attitudinal variables was correlated with verifiable
evasion but not with self-reports of evasion while another set of attitudes were correlated with self-reports but not
with verifiable behavior. Self-reports and verifiable behavior were uncorrelated with both evaders and compliers
(per verifiable records) giving inaccurate self-reports.(11) Many problems attributed to TCMP data are also shared
by self-reports. For example, like tax administrators, taxpayers are biased judges of their own compliance and may
not report cases of abuse or exploitation if they do not interpret them as "noncompliance." Finally, much fiscal
psychology research deals with the measurement of attitudes and behavior intentions rather than actual behavior.
While this may sometimes be necessary with a sensitive subject like tax evasion, the requisite link between
attitudes and actions is missing [Einhorn and Hogarth, 1981].
Fiscal psychology research is not limited to surveys. Spicer and Becker [1980] used experimental methods to
examine the impact of perceived fiscal inequity on compliance. They operationalized inequity as the belief that
other taxpayers faced relatively higher or lower tax rates than others. The belief that others faced a lower (higher)
tax rate led to less (more) compliance. Economic incentives were controlled by holding actual tax rates constant
across subjects and only manipulating the rate believed to be faced by others. Becker, Buchner and Sleeking
[1987] also used an experimental setting to examine the effects of taxpayers' perceived tax burdens,

operationalized as unequal transfer payments, along with income and audit probability, on compliance. In addition
to manipulating the percentage of expected government expenditures received by the taxpayer, they also solicited
subjects' perceptions of their tax burden. Consistent with the predictions of most economic models, the audit rate
(income level) had a positive (negative) effect on compliance. Further, both the amount of actual government
expenditures received and the perceived tax burden were positively related to compliance.
Fiscal psychology research may suffer from more than a methodological shortcoming. In the terminology of Tittle
[1980], the studies have documented relationships between various demographic and attitudinal variables and
compliance, but have often failed to identify the mechanism through which the relationships exist or operate. Until
such mechanisms are identified, and the constructs can be meaningfully measured, this line of research may have
reached a theoretical plateau.
3.0 Summary and Future Research
3.1 Discussion of Economic-Based Compliance Research
Recall it was suggested that economic models might add the motivation for deviant behavior that general
deterrence models lack by allowing for the quantification of noncompliance costs and benefits. However,
economic models have subsequently been criticized for discounting the motivational effects of factors which
cannot be measured monetarily. The importance of other factors in the reporting decision is apparent from
examining actual taxpayer behavior. Given the models reviewed above and the current level of economic
incentives (i.e., audit probabilities and penalty levels), the real question should be why people pay taxes at all, not
why they evade [Graetz and Wilde, 1985; Alm, 1991; Alm, McClelland and Schulze, 1992]! Yet, the majority of
taxpayers do comply with the tax laws.(12) It can be argued, therefore, that economic incentives must be relatively
unimportant, which makes economic models suspect since they ignore noneconomic factors.
But economic modelling of taxpayer compliance should not be dismissed so easily. Using similar reasoning, one
would expect no cheating if there were no economic consequences of paying taxes! Given any noncompliance
then, it must be assumed the economic benefits are non-trivial. While there may be a number of noneconomic
factors inhibiting noncompliance, and these noneconomic phenomenon cannot be ignored in any predictive model
of tax reporting, the preponderance of evidence suggests that some level of noncompliance is related to economic
factors. At least at the margin, if the cost of cheating increases, some cheating will be dissuaded--and the actions
of those at the margin can make a significant difference. Ignoring the economic incentives would be just as big a
mistake as ignoring other factors.
3.2 Summary of Previous Findings
While previous research regarding the effects of some economic incentives on taxpayer compliance has been
relatively consistent, results regarding others has yielded inconclusive results. For example, detection probability
and penalty level have been consistently found to have positive, direct effects on compliance.(13) As illustrated in
Table 1, predictions based on analytical models have been verified using both econometric methods and
controlled laboratory experiments. As shown in Table 2, it has been suggested that uncertainty surrounding the
audit strategy should further enhance its effectiveness. Penalty and detection rates are also expected to have
positive indirect effects on compliance by enhancing the effects of tax liability uncertainty and by increasing the
expected benefits to the taxing authority of auditing.
Evidence regarding the effects of taxpayer income and tax rates on compliance, however, has been less
consistent. As shown in Table 1, if taxpayers are risk-averse, or act as if they are risk-averse due to the existence of
a progressive tax, increased income should lead to decreased compliance. While Becker, Buchner and Sleeking
[1987] provide corroborating experimental evidence, Alm, Jackson and McKee [1992a] find a positive effect of true
income on reported income. However, note that while subjects in Alm, Jackson and McKee faced a random audit
strategy, their responses are consistent with the predictions of strategic models shown in Table 3. When strategic
actions of the taxing authority are considered, reported income should increase with true income since the benefit
of auditing, of which the taxpayer is aware, is also increasing. The inconsistent predictions of traditional and
strategic models are evidenced in conflicting econometric work as well. Of course, the confounding of income and

tax rates in archival data could contribute to the inconsistent results. As can be seen in Table 3, experimental tests
of interactive models which could control for such confounding are lacking.
Regarding tax rates, even the simplest analytical models offer conflicting results. If taxpayers are decreasingly
risk-averse, increased tax rates are expected to have a positive effect on compliance due to lower after-tax income
(i.e., the income effect). If penalties are based on unreported income, an increase in tax rates would also make
reported income relatively more costly, resulting in an offsetting substitution effect. If penalties are based on
unpaid taxes, however, there should be no substitution effect. While these predictions have been supported
experimentally by Beck, Davis, and Jung [1991], Friedland, Maital and Rutenberg [1978] and Alm, Jackson and
McKee [1992a] found a compliance-inhibiting effect of higher tax rates. While relaxing the risk aversion
assumption results in the elimination of the compliance-enhancing income effect, it cannot explain the
compliance-inhibiting effect found by Friedland, Maital and Rutenberg and Alm, Jackson and McKee. Finally, it has
been suggested that uncertainty surrounding the tax rate would mitigate any compliance-enhancing effect for risk-
averse taxpayers.
Unlike predictions regarding income level, predictions of tax rate effects on reported income do not change when
strategic auditing by the taxing authority is considered. When the taxing authority is added as a strategic actor, the
increased returns of auditing as tax rates rise further encourage compliance. These predictions have been
supported experimentally. However, studies employing archival data have found tax rates to be negatively related
to compliance. Tax rates have also been suggested to have an indirect effect on reported income by enhancing the
effect of tax liability uncertainty on risk-averse taxpayers.
Finally, the potential influence of preparers on taxpayer compliance has been examined. Uncertainty resolution
provided by preparers regarding unambiguous income should increase compliance, but may also reduce
overreporting. If penalties related to ambiguous items are relatively weaker than those related to unambiguous
items, preparers may also use ambiguity to exploit the law in taxpayers' favor. Finally, preparers may result in lower
reported income absent any informational services merely by shielding taxpayers from audit and enforcement
costs.
3.3 Factors Deserving (More) Attention
The above discussion suggests a number of areas in which additional experimental work is needed to test existing
models. A review of Table 1 suggests that many relatively simple models, such as that of Koskela [1983] dealing
with the effects of compensated changes in tax rates, have yet to be tested in a laboratory. Similarly, the general
equilibrium models of Reinganum and Wilde [1986] and Graetz, Reinganum and Wilde [1986] offer several
hypotheses regarding the effects of tax structure and true income in a strategic framework. Klepper, Mazur and
Nagin [1991] and Reinganum and Wilde [1991] also offer hypotheses regarding the ambiguity reduction and
insurance aspects of professional preparers. Experimental economics provides a means of testing such well-
formulated, well-articulated models.
Where formal models do not exist, or do not yield clear predictions, experimental economics can be used to
identify potentially relevant factors affecting compliance, with the results contributing to subsequent theory
development. One example of such an application was the early examinations of the effects of tax amnesties on
compliance [Alm, McKee and Beck, 1990; Alm, Jackson and McKee, 1992c]. Examination of the current tax
environment yields a number of other factors that may potentially influence taxpayer compliance and/or
aggressiveness that have received little attention. These include self-audits (however, see Hemmer, Stinson and
Vaysman [1994]); positive monetary incentives (however, see Alm, Jackson and McKee [1992c]); the availability of
audit and/or tax liability insurance; strict liability penalties versus those based on culpability; ambiguity
surrounding tax reporting standards; paid preparer audits; disclosure and substantiation requirements (e.g.,
Sansing [1993]); the conditioning of preparer fees on reported taxpayer liabilities; shifting preparer compensation
to the taxing authority; the use of independent examiners rather than government auditors or privately-paid
preparers to prepare returns and settle taxpayer disputes (i.e., thereby shifting the reward structure); and allocation
and appointment opportunities (across taxpayers, jurisdictions, etc.). While the direct effects of several of these

factors on evasion may seem intuitive, others are not. Even those with seemingly intuitive effects on evasion may
affect taxpayer decisions under tax liability uncertainty differently, or interact with the corresponding ambiguity,
tax structure or auditing scheme to produce unexpected results. Most of these factors can be examined within the
framework of the basic models discussed earlier and would be of immediate interest to policymakers.
3.4 "Mixed Models"
As discussed above, accounting researchers have begun examining the effects of noneconomic factors on
compliance. Much of this work has examined the main effects of psychological and demographic factors,
implicitly viewing them as additional factors in an additive compliance model. Other studies explicitly set up
economic and attitudinal models as competing perspectives, attempting to identify which is more "valid" or
"appropriate" [e.g., Schwartz and Orleans, 1967; Tittle, 1980; Milliron and Toy, 1988]. However, economic and
noneconomic perspectives need not be viewed as competing alternatives. It was suggested by early fiscal
psychologists that the attitudes and perceptions of economic actors served as moderating variables between
economic stimuli and responses. Perhaps a more fruitful approach to compliance research is to "show that
intervening variables such as attitudes can be observed and investigated, and that these investigations can
improve predictions and the comprehension of economic phenomena" [Lewis, 1982, p. 21]. Two possibilities are
offered.
The first is that attitudes and economic factors relate to different hierarchical strategies (Carroll [1987]). For
example, taxpayers may make two levels of decisions: whether or not they want to remain open to noncompliance
opportunities if and when they arise; and the tactical choice regarding specific opportunities. Willingness to
remain open to noncompliance opportunities may be dependent on attitudes and demographic factors. Tactical
choices regarding specific opportunities may be more dependent on the economic factors related to those
opportunities. The possible use of such a hierarchical decision process may have several implications. For
example, encouraging noncompliant taxpayers to re-evaluate their overall strategies (i.e., to leave the
noncompliance business) would make economic factors related to specific tactical choices irrelevant. While
economic incentives may still be important for those choosing to remain open to noncompliance opportunities,
their effects may be masked in studies of broad cross-sections of taxpayers with different overall strategies.
A second possibility is that attitudinal and economic factors interact in a more configural fashion. This would
suggest that the next step for many analytical models, after mathematical and experimental verification, would be
to determine how individual attitudes and other contextual factors might moderate economic incentives. While
most experimental economics studies are specifically designed to avoid the impact of non-economic factors,
similar methods might be modified to examine both in the same setting.
The use of experimental methods to examine the impact of perceived fiscal inequity on compliance was discussed
previously. However, these studies either failed to explicitly consider the related economic incentives at all [Spicer
and Becker, 1980] or failed to consider their potential interaction with equity perceptions [Becker, Buchner and
Sleeking [1987]. Future research should recognize and examine these potentially interacting/confounding
influences. For example, Moser, Evans and Kim [1993] note that the conflicting results regarding the effects of tax
rates on compliance may be due to a confounding of related economic and noneconomic factors. They
hypothesized that while a higher tax rate provides economic incentives to report more income, it may also
negatively affect perceptions of the exchange equity between the taxpayer and the government. The negative
impact on compliance of the perceived inequity should offset any compliance-enhancing incentives of the tax rate.
Further, if taxpayers feel their effective rate is higher than that faced by others, the perceived horizontal inequity
should lead to the net decrease in compliance observed by Clotfelter [1983] and Alm, Bahl and Murray [1993]. To
test their hypotheses, Moser, Evans and Kim manipulated both the actual tax rate faced by their subjects as well
as the rare believed to be faced by others. As predicted, higher tax rates had no (a negative) net effect on subjects'
reported income when they believed they had the same (higher) rate as other subjects.
In addition to attitudes, other contextual features may moderate the predictions of economic models. For example,
it has been shown both analytically and experimentally that uncertainty affects taxpayer reporting. "Uncertainty" is

usually modelled as a mean-preserving spread over a distribution. However, uncertainty may result in more than
increased variance regarding judgments. For example, increased ambiguity surrounding substantiation and
reporting standards may provide more opportunity for related attitudes and biases to operate.
Earlier studies point out several issues related to using economic-based laboratory method to examine non-
economic factors. These include the over-emphasis of economic factors in the experiment (e.g., participants are
often encouraged to cheat so as to allow the effects of economic (dis)incentives to be observable) and the use of
student subjects who may not understand the relevant contextual factors or possess the relevant attitudes and
biases. These factors may contribute to the finding of Becker, Buchner and Sleeking [1987] that compliance
among their subjects increased with their perceived tax burdens. The interaction of economic and non-economic
factors may be better examined in an experimental setting that utilizes both subjects and settings with more
external validity. For example, Cuccia [1994] examined tax professionals' interpretations of ambiguous tax issues
in a simulation in which the interaction of economic and noneconomic consequences were considered. He found
that differences in attitudes across different preparer types moderated the professionals' responses to penalty
threats.
3.5 Redefining the Reporting Decision
Most compliance research has considered the reporting decision as being made at the time of filing, unrelated to
any other decisions or underlying transaction. If detected, all underreporting is subject to a set penalty rate.
However, reporting decisions faced by taxpayers are much more complicated, involving numerous decisions at
various points in time and subject to different consequences. This suggests that the decision context examined by
researchers could be expanded. For example, Collins and Plumlee [1991] examined a joint decision involving the
reported tax liability and the amount of labor to be supplied by a taxpayer. Erard [1990; 1993] examined the joint
decision involving compliance and preparation mode (i.e., self- versus professionally-prepared) . Reporting
decisions may also be made jointly with related investment or financing decisions (i.e., tax planning versus tax
compliance). Broadening the decision context to include these related decisions would suggest an entirely new set
of factors which might influence reporting decisions. These might include the riskiness of a related investment, the
cost of the financing tool, and any special tax treatment given the particular transaction.
While generally expanding the decision context examined across studies, researchers should simultaneously limit
the nature of both the decision and the decision-makers under examination in a single study. Given the broad
range of decision contexts alluded to above, it is unlikely that one theory or study can adequately describe or
predict all types of decisions or contexts. For example, care should be taken to explicitly define the nature of
underreporting being examined. As previously discussed, the basic economic model of compliance has been
expanded to include income uncertainty. The possibility of income uncertainty also raises the issue of culpability.
Assessment of a penalty generally requires the taxing authority to show negligence or willful understatement,
resulting in very few penalties actually being assessed. However, even models that allow for tax liability
uncertainty generally retain the assumption of a penalty applied to all detected understatements. The sole
exception is Beck and Jung [1989b]. A modified/expanded model may be more appropriate for incorporating
ambiguity and culpability in the economic model of tax reporting.(14)
Finally, as discussed above, individual compliance is affected by noneconomic factors such as attitudes regarding
the tax laws, the administration of those laws, and perceptions of equity. However, some dimensions of
compliance may be much less affected by these factors. As pointed out by Lewis [1982, p. 31], the economic
model of man "was used first and foremost in the analysis of the economic behavior of businessmen. And, indeed,
the model may be more appropriate for businessmen than consumers." Two areas in which economic-based
research may prove more immediately useful than individual compliance may be the effects of economic stimuli
on professional preparers and corporate compliance. Both cases involve business decisions being made in a
relatively public domain. Such decisions may more likely be part of an overall profit-maximizing plan and
influenced less by personal attitudes and biases. Models involving professional preparers were discussed
previously; however, those models typically examined the effects of preparer services on taxpayer reporting rather

tan examining the effects of economic incentives on preparers directly.
3.6 Other Models of Individual Decision Making
As discussed above, corporations and professional preparers may conform more closely than individuals to the EU
model underlying most economic-based compliance research. In fact, the EU model has come under attack by
researchers in numerous domains as a model of individual choice (e.g., Schoemaker [1982] and Machina [1987]) as
observed decisions often fail to conform to the predictions of the theory. Variants of the EU model, such as
prospect theory (Kahneman and Tversky [1979]), have recently been applied to tax compliance decisions but have
yielded inconsistent results (e.g., Chang, Nichols and Scholtz [1987]; Hite, Jackson and Spicer [1988]; Schadewald
[1989]; Robben, Webley, Elffers and Hessing [1990]; Robben, Webley, Weigel, Warneryd, Kinsey, Hessing, Martin,
Elffers, Wahlund, Van Langenhove, Long and Scholz, 1990; Schepanski and Kelsey [1990]; Dusenbury [1994]; White,
Harrison and Harrell [1993]).
As a variant of EU theory, many of the noneconomic factors which moderate the effects of economic stimuli in
tests relying on EU theory will also affect examinations invoking prospect theory. An additional problem for
prospect theory researchers may be the failure to identify, or to make salient in a laboratory setting, what reference
points might serve to frame taxpayers' reporting choices as involving potential gains or losses. While most studies
have assumed that the amount of tax due/overpaid at filing might frame the reporting choice, other possible
reference points include previous liabilities, variances from current year estimates, or comparisons with other
taxpayers. Conditions and decisions occurring at times other than filing may also affect taxpayers' framing of the
reporting decision.
Other potential shortcomings are common to most EU variants. For example, most utility models implicitly view
the current decision as one of a number of decisions, so that actual outcomes approach their expectation.
However, tax reporting choices (especially those involving tax liability uncertainty) may more likely be viewed as
isolated decisions and, therefore, not conform to any variants of the expected utility model. Future research should
examine if a multiple-play perspective is an accurate depiction of the taxpayer reporting decision, and how
decisions might be different if a single-play perspective were more appropriate.
4.0 Summary and Conclusions
Economic-based compliance research is useful in identifying underlying motives for taxpayer reporting. While
economic models alone may not predict taxpayer reporting decisions due to individual attitudes and biases,
economic incentives are important factors in understanding taxpayer behavior.
Economic-based compliance research should go through three related stages to be of maximum utility: (1) model
development where internal validity is verified; (2) empirical or experimental verification where construct validity is
tested and the theory is checked for completeness; and (3) integration of the model with: other confounding or
mitigating factors which may affect external validity and predictive ability. The third stage may be the most critical
if research is to contribute to the understanding of actual taxpayer behavior. Economic-based research is often
criticized for lacking predictive ability due to its exclusion of taxpayer attitudes and beliefs. Behavioral and
attitudinal compliance research is also criticized for its lack of focus and underlying theory. It appears that only by
integrating approaches and directing examinations toward small groups of taxpayers with homogenous
incentives, both economic and attitudinal, can any contributions to understanding actual decisions be made.
Accountants may add to economic-based compliance research at all three phases described above. First,
accountants are familiar with the broad range of contexts and environments in which tax compliance decisions are
made and the concerns of those who make them. This knowledge should be useful in model development and
testing. Perhaps more importantly, accountants' familiarity with behavioral, attitudinal and contextual factors
provides a competive advantage in integrating these factors with related economic incentives, pulling together
perspectives from different disciplines, and identifying potentially mitigating or confounding factors which may
improve the predictions of economic models.
1 Notable exceptions are Alm [1991] who reviews some considerations regarding the empirical testing of
economic models of compliance, and Fischer, Wartick and Mark [1992] who review in detail the literature regarding

detection rates.
2 Allingham and Sandmo [1972] recognized that noneconomic factors may also affect taxpayer decisions. They
noted that income and reputation may be substitutes in the cardinal sense, and that the same economic
parameters may result in different decisions by taxpayers who value reputation differently. However, this had no
bearing on their basic findings.
3 Polinsky and Shavell [1979] argue that while extremely low detection rates and high penalties may be effective in
deterring undesirable activities, they are not seen in practice because the resulting loss in utility due to risk bearing
will exceed the benefits from controlling evasion. In fit, they show that if the costs of detection are low enough,
social welfare may be optimized by setting the probability of detection equal to one.
4 This finding was consistent with Alm [1988] and Scotchmer and Slemrod [1989] who also found a compliance
enhancing effect of increased ambiguity for risk-averse taxpayers.
5 Allingham and Sandmo [1972] considered the potential endogeneity of audit probabilities, but limited their
examination to the effects of penalty and audit probability on reported income. They concluded the effects of
these parameters on reported income were not changed by the endogeneity of audit rates.
6 This is descriptive of a setting in which taxpayers are otherwise indistinguishable (i.e., are of the same audit
class) except that some are entitled to a particular deduction.
7 Scotchmer [1987] notes that such a bias may be offset, however, if there are a number of audit classes which are
good predictors of true income and there is a stochastic signal regarding true income available to the Taxing
Authority. In this case, high (low) signals will cause a taxpayer to be considered in the next higher (lower) class, but
at its lower (upper) end, and therefore (not) subject to audit. This adds extra progressivity to the effective tax
structure across classes, offsetting the regressive bias within classes.
8 The relationship between tax rates and income levels which, in a progressive system, are necessarily correlated
result in a multicollinearity problem and unstable estimates of both parameters. This is discussed further below.
9 Conversely, Spicer and Thomas [1982], using a similar methodology, found that increasing audit rates had no
affect on the amount of tax paid by their student-subjects unless the audit rate was known wish relative certainty.
10 However, see Alm, Jackson and McKee [1992a] for evidence that the explicit use of a tax setting instead of a
"neutral" context may not affect the results of experimental tax compliance research.
11 Of course, another possibility that could explain the results is that the validity of the official records are
questionable. Elffers, Robben and Hessing [1991] suggested that even results of detailed government audit
programs lack reliability and, therefore, may be just as suspect as valid measures of compliance as self-reports.
12 In fact, recent reports indicate that only about 2 out of every 1,000 returns is fraudulent [Long and Swingen,
1991, p. 644].
13 See Fischer, Wartick and Mark [1992] for a detailed review of the detection probability literature, including
different ways in which it has been operationalized and measured across studies.
14 Klepper and Nagin [1989a] and Klepper, Mazur and Nagin [1991] considered culpability when looking at the
effects of tax preparers on reported income. They assumed that penalties related to items with ambiguous tax
consequences were imposed on all underpayments but were less severe than those related to items with
unambiguous consequences. An alternate explanation with similar consequences is that the penalty on
ambiguous income is relatively lower because it is an expected mean penalty resulting from e statutory penalty
imposed on detected underpayments with less than 100 percent certainty. However, uncertain application of the
penalty may have effects on reporting other than resulting from a lower expected penalty.
1. Allingham, M. and A. Sandmo. 1972. Income tax evasion: A theoretical analysis. Journal of Public Economics 1
(November): 323-338.
This is one of the first applications of Becker's [1968] economics of crime model to tax compliance. Allingham and
Sandmo model the individual's compliance decision as one made under uncertainty. Taxpayers are assumed to be
decreasingly risk-averse. A taxpayer chooses between reported income which is subject to tax at a known rate, and
unreported income, subject to an exogenously determined probability of detection and an additional penalty, based

on the underreported income, if detected. Both the detection rate and penalty level are known with certainty.
Allingham and Sandmo show analytically that deliberate underreporting will decrease as the probability of
detection and the penalty rate rise. However, the effect of the tax rate on compliance is ambiguous. While an
increased tax rate increases the return on unreported income (i.e., the substitution effect), it also reduces net
income, making the taxpayer relatively more risk-averse (i.e., the income effect).
2. Beck, P. and W. Jung. 1989. Taxpayer compliance under uncertainty. Journal of Accounting and Public Policy 8
(Spring): 1-27.
Beck and Jung extend the economic models of Allingham and Sandmo and others in several ways, including
conditioning the penalty for underreporting on the underpaid tax rather than unreported income (as it is in the
current income tax system), and relaxing the assumption of risk-averse taxpayers. The change in the penalty
structure affects the relationship of tax rates and compliance. Since a penalty based on unpaid tax will increase
with the tax rate, there should be no compliance-inhibiting substitution effect. An increase in tax rates, therefore,
should result in only a compliance-enhancing income effect if taxpayers are risk-averse. However, if taxpayers are
risk-neutral, the income effect is also lost and tax rate are predicted to have no effect on compliance. The effect of
income uncertainty is also considered. It is shown that uncertainty will increase compliance only for those already
reporting conservatively while those reporting aggressively may actually reduce reported income.
3. Beck, P., J. Davis and W. Jung. 1991. Experimental evidence on taxpayer reporting under uncertainty.
Accounting Review 66 (July): 535-558.
Beck, Davis and Jung use experimental economics techniques to test the predictions of Beck and Jung [1989].
Student subjects' risk attitudes were experimentally controlled via the payoff rules. Empirical results were
consistent with the model's predictions for risk-neutral taxpayers, with both penalty and audit rates positively
related to reported income, and tax rates having no effect. Uncertainty led to higher reported income when the
audit rate was high, but lower reported income when the penalty rate was low. Results for risk-averse taxpayers
were less conclusive. Consistent with predictions, higher (lower) tax rates led to higher (lower) reported income
(i.e., due to the income effect). Similarly, uncertainty enhanced the effect of tax rates, increasing (decreasing)
compliance when rates were high (low).
4. Clotfelter, C. 1983. Tax evasion and tax rates: An analysis of individual returns. The Review o Economics and
Statistics (August): 363-373.
Clotfelter tested the relationship of tax rates and compliance using archival data--the 1969 Taxpayer Compliance
Measurement Program. Segregating the data by audit class and type of return to avoid the problem of endogenous
audit rates, and controlling for complexity and opportunity; he found that both income and tax rates were positively
associated with detected evasion. The results regarding tax rates were inconsistent with prior economic models
which hypothesized, given a penalty based on unpaid tax, a negative relationship if taxpayers were risk-averse, or
no relationship if taxpayers were risk-neutral. While these results might be attributed to shortcomings in the data
(e.g., tax rates and income may be correlated in cross-sectional data, yielding unreliable parameter estimates), the
results have been supported in later laboratory studies (e.g., Alm, Jackson and McKee [1992a]).
5. Spicer, M. and L. Becker. 1980. Fiscal inequity and tax evasion: An experimental approach. National Tax Journal
33: 171-175.
Spicer and Becker used a laboratory study to examine the effects of perceived, relative tax rates on compliance.
While economic considerations lead to predictions of positive or no effects of tax rates, depending on the risk
attitudes of taxpayers, perceptions of fiscal inequity may cause those who believe they face higher tax rates than
their peers to reduce compliance. Subjects were given an experimental income and asked to report and pay their
tax liability. While all subjects faced the same tax rate. they were told that their tax rates were either higher, equal
to, or lower than others. Those who believed others faced higher rates complied most while those who believed
others faced lower rates complied least, suggesting the perceived equity of the tax affected reporting. While actual
tax rates did not change across subjects, these results may offer some insight into the results observed by
Clotfelter. If taxpayers accurately perceive their relative tax rates (perhaps due to the availability of deductions and

credits), perhaps the perceived equity of the rate has a larger effect on actual compliance than any compliance-
enhancing income effect which may be present.
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The helpful comments of the Co-Editor, Bill Messier and two anonymous reviewers are gratefully acknowledged.
DETAILS
Business indexing term: Subject: Tax rates Compliance Econometrics Taxation economics Cost control
Taxpayers Sanctions Expected utility Tax collections Tax evasion
Subject: Studies; Research; Tax rates; Compliance; Econometrics; Taxation economics; Cost
control; Taxpayers; Sanctions; Expected utility; Tax collections; Tax evasion; Criminal
statistics; Deviance; Perceptions; Hypotheses; Decision making; Fines &penalties;
Noncompliance
Location: United States--US
Publication title: Journal of Accounting Literature; Gainesville
Volume: 13
Pages: 81
Publication year: 1994
Publication date: 1994
Publisher: Elsevier BV

Place of publication: Gainesville
Country of publication: Netherlands, Gainesville
Publication subject: Business And Economics--Accounting
ISSN: 07374607
e-ISSN: 24521469
Source type: Scholarly Journal
Language of publication: English
Document type: PERIODICAL
Accession number: 00526472
ProQuest document ID: 216310381
Document URL: https://www.proquest.com/scholarly-journals/economics-tax-compliance-what-do-

we-know-where-go/docview/216310381/se-2?accountid=38384
Copyright: Copyright University of Florida, Accounting Research Center 1994
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