Self-control: A tax short story


Luis is a Colombian entrepreneur. Last year, his company went bankrupt for failing to pay taxes at the end of the year. In Luis’s view, a recent change in Colombia’s taxation law was the reason that encouraged him to take the wrong choices for his company.

When governments design policies, they act as choice architects. It means that they have the power to influence people’s behaviour in a desired way. In Luis’ case, a change in Bogotá’s tax policy resulted in him declaring bankruptcy.

Impact of Colombia’s tax policy on Luis’ psychology

Bogotá, Colombia’s capital, contributes to 26% of Colombia´s GDP and was named the 3rd best Latin American City by World Bank’s Doing Business ranking.  Bogotá made important changes on payments’ frequency for corporate income tax called ICA. Between 1994 to 2016, ICA had to be paid by companies bimonthly. On 1st of January of 2017 ICA was changed to be paid annually.

For small companies such as the one owned by Luis, it now means that every two months, companies have an “extra” cash inflow available. Although the “extra” cash flow was not his, now Luis had to save it for the government until the end of the year. This presented Luis with a self-control problem, which tends to arise when choices and consequences are separated in time [1]. The problem: Luis had to choose between saving money for the future tax payment, or use it now for his company’s present liquidity needs.

Although the “new money” was not extra income resulting from the company’s operation, Luis gave in into the temptation to divert money from its tax purpose and instead used it as working capital. He planned to collect enough tax money from the day-to-day operations by the end of the year. For Luis the consequence of using the extra tax money today was moved to the future.

However, when the end of the year came, Luis found himself unable to pay taxes and his company had to be declared bankrupt. In Thaler ’s model of self-control [2], the planner and the doer faced different incentives that left Luis worse off.

Economic theory predicts that Luis would have saved the “extra” income

In traditional economic models, tax compliance is generally explained under an expected utility framework that states that factors such as audit probability, fine rates or the return of a public good define taxpayers’ behaviour [3].

Moreover, under economic analysis, humans and firms are rational agents that predict and take optimal inter-temporal decisions on their consumption and savings. Luis’ situation never should have happened under these models. When the Colombian government changed tax return periodicity of payment from bimonthly to annually, economic models predict that fully rational agents would save enough money from each period until tax payday arrives at the end of the year.

Behavioural science theory predicts self-control problems

We all have been there. We happily get a one-year subscription to the gym, go for two or three weeks and then never return. Although regular gym sessions are better for us in the long-term, we tend to postpone them in favour of present desires. Just as humans have self-control problems, so do companies run by humans. When we recognize self-control problems in human’s behaviour, Luis situation does not look so unfamiliar.

While governments seem to recognize that humans might suffer self-control problems related to tax behaviour, their actions have been very limited. They merely recommend tax payers to save, without addressing self-control issues in the design of their tax policy.  

For example, in the US, the Internal Revenue Service (IRS) recommend that self-employed taxpayers make quarterly estimated payments during the year to avoid problems at tax time. This recommendation can be extended to small and medium companies given that they behave similarly to self-employed taxpayers.

However,  tax return periodicity is designed by the government to reduce administration costs through the less frequent filing of tax returns. This suggests that a search for greater efficiency in tax collection could worsen self-control issues, as higher efficiency implies lower periodicity, and this forces self-employed and companies to save money for longer.

Certainly, Luis case is not evidence of every Colombian taxpayer. A typical behaviour should be defined before to extend this analysis and application in tax policy design. However, addressing self-control issues in taxpayers might be a useful tool for explaining Luis case and be a potential tool for future tax policy research.

References

[1] (2008). Richard H. Thaler, Cass R. Sunstein, Nudge: Improving decisions about health, wealth, and happiness.

[2] (2008). Richard H. Thaler, Cass R. Sunstein, Nudge: Improving decisions about health, wealth, and happiness.

[3] (2007). Blackwell C. ‘A Meta-Analysis of Tax Compliance Experiments’, International Center for Public Policy Working Paper Series at Andrew Young School of Policy Studies, Georgia State University.

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