How tax systems impose psychological burdens on taxpayers

• The problem: Tax systems are highly complex and rarely comprehensible
• Why it matters: Complying with obligations correctly taxes people’s brains, especially in developing countries
• The solution: Making systems clearer and providing the right motivation can lead to better tax decisions

In a recent project, the Indonesian Government and the World Bank developed interventions to support taxpayers' compliance through simple yet innovative communications. Working with 24,000 small and medium enterprises (SMEs), it had surprising results — that stretched beyond encouraging compliance.

It's tax season. Get your paperwork ready, brush up on your maths, and…pay! But it’s never quite that simple. For many taxpayers, the amount of information you have to go through is overwhelming and confusing. You could be short on time or cash, and complying with your taxes might compete with other obligations. Your anxiety builds, as does the threat of being audited — however remote that is.

Now, imagine you are also the owner of a small business in a developing country like Indonesia. Many of your transactions are informal, your profits are small and unpredictable, and you lack management and accounting skills. You might not even be aware of your tax obligations. So how can the authorities improve SMEs’ tax compliance?

The amount of information you have to go through is overwhelming and confusing.

Beyond money, tax systems impose other burdens on taxpayers. Time is an obvious one, but taxpayers also face uncertainty, anxiety, and confusion, which could limit their awareness, motivation, and capacity to pay taxes.

A large, untapped revenue source

Indonesia, the largest economy in Southeast Asia, is home to almost 60 million SMEs. This sizeable sector of the economy contributes around 60% of domestic value addition, 97% of employment, 15% of exports of the country (ADB SME Monitor 2020).

This suggests that SMEs could potentially make an important contribution to government revenue. The government implemented a broad tax reform in 2016 to modernise the collection system and incentivise declaration and compliance. It then introduced another reform in 2018 (Government Regulation PP 23/2018), expanding the tax base among SMEs and reducing their tax rate.

Currently, SMEs with annual gross income below 4.8 billion Indonesian Rupiahs (roughly US $335,000) should declare and pay 0.5% of their monthly turnover in tax each month. However, most SMEs operate informally, with limited access to financial, legal, and digital resources. In effect, only 15% of registered SMEs comply with their obligations (Directorate General of Taxes 2018).

Tahu, mau, mampu

The Directorate General of Taxes (DGT), Indonesia's tax authority, the World Bank's Indonesia country team, and the Mind, Behavioral, and Development Unit (eMBeD) set out to understand the barriers to tax compliance experienced by SMEs. The teams conducted a survey to capture the awareness (tahu), willingness (mau), and capacity (mampu) of owners and managers of 750 SMEs to pay taxes (IPSOS 2016).

This research revealed that most firms did not fully understand the requirements, procedures, and benefits of tax policy. More importantly, they were not aware of their own eligibility to pay taxes and could not find helpful information.

The willingness of firms to meet their tax duties was mainly driven by a feeling of obligation as citizens, a sense of relief after paying, and the possibility of obtaining business permits. However, most SMEs did not consider penalties or monitoring from the tax authority as enough reason to pay, indicating a perceived lack of enforcement.

Lastly, respondents believed that their businesses were not mature and stable enough to bear the financial burden of tax. This suggests that high informality among SMEs is a structural challenge to tax compliance in Indonesia.

Keeping in touch - little and often

Together, the DGT and World Bank teams aimed to tackle some of the challenges identified in the initial research, and improve the awareness and willingness of SMEs to pay taxes. The teams designed desk calendars that worked as a tangible, year-round reminder of their monthly obligations and conveyed behaviorally-informed messages using three distinct framings.

The first framing delivered concise information about the tax. The messages included, for example, a rule of thumb for calculating the amount due, a list of payment options, and reminders of the due date. The messages also included a catchy mnemonic: paying taxes is WISE, an acronym for tax-compliant business in Indonesian.

The second framing included the simplified information from the first one and stressed the public benefits from tax revenues. It included figures on the contribution of taxes to more equitable income distribution, public infrastructure, and access to education for low-income students.

The third framing added a deterrence element to the information provided in the first one. Messages emphasised the monitoring capacity of tax authorities, the potential for penalties, and a general reminder to avoid the hassle of fines.

To assess the effectiveness of the framings, the team randomly shipped the calendars to 18,000 SMEs with the support of 40 local tax offices. From September 2018, we followed the monthly payments of each SME that received a calendar, along with those from a control group of 6,000 SMEs that did not receive one.

Tangible results

The trial in Indonesia was highly effective in improving tax compliance. After 15 months, participants’ monthly payment rate increased by 4% and the amount they paid by 7%, compared to the group without calendars.

Interestingly, we saw that the framings affected the compliance behavior of SMEs differently. The deterrence framing reduced delinquency by increasing the payment rates of non-complying SMEs by 5%, compared to non-compliers from the control group. And complying firms increased the monthly amount they paid by 12% after receiving simple information or facts about the public benefits of taxation, when compared with compliers from the control group.

The intervention demonstrates how impactful and valuable behavioral sciences can be for tax policy, at little cost. A cost-benefit analysis showed that the total net revenue collected from the intervention was IDR 28.9 billion (US $2 million), representing a 3% increase for participating offices.

Given these positive figures, the DGT will expand the intervention, distributing additional calendars to a larger group of taxpayers across the country. World Bank teams continue supporting tax authorities from developing countries in the design and test of innovative ways to reduce the psychological burdens of tax systems and increase domestic revenue. — Jorge Luis Castaneda

If you want to learn more about this project, follow this link to access a result brief or this link to see the activity report. Also, for more examples of World Bank’s behavioral initiatives on tax compliance, follow this link.

Originally posted on apolitical.co