Effects of tax payment systems on tax compliance: Comparing the withholding system with the tax declaration system

Abstract

I investigate using experiments whether an individual’s tax compliance level varies with the method of collecting income tax, comparing: 1) a withholding tax system, in which income tax is withheld from income before the taxpayer is paid, and 2) a tax declaration system, in which taxpayers must self-declare their income in order for tax to be calculated and paid after the corresponding business period. Under expected utility theory, there is no difference between these two systems. However, under prospect theory, taxpayers perceive the two tax payment systems differently. In the tax declaration system, paying tax may be perceived as an expenditure or loss for the taxpayer that may strongly elicit loss aversion. Conversely, in the withholding tax system, taxpayers receive a partial refund or pay an additional tax much smaller than what they would pay under the tax declaration system. As a result, elicited loss aversion is much smaller than in the tax declaration system. Therefore, the withholding tax system may achieve higher tax compliance than the tax declaration system. Results show that the tax compliance rate is 100% when taxpayers pay too much advance tax. A tax evasion rate of 35.3% is observed in the withholding system when too little advance tax is paid. In the tax declaration condition, the rate of tax evasion is 50%, significantly higher than for the withholding tax condition even in the presence of under-withholding. Furthermore, this effect was sustained during all five experimental periods. Thus, even though the amount of tax due is unchanged, the payment method affects the degree of individuals’ tax compliance.