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Combating tax evasion psychologically

New study: prefilled deductions enhance tax compliance

Prof Dr. Overesch vor einer Ziegelwand und einem senkrechten WISO-Schriftzug

Tax evasion is a problem that consumes considerable resources to combat. Deductions in tax returns are the main way in which many taxpayers evade taxes.

In a recent study, WiSo professor Michael Overesch, together with Martin Fochmann, Tobias Kölle and Frank Hechtner, took a closer look at this issue. In a recently published article, the researchers analyze three anti-tax-evasion instruments targeting deductible expenses in terms of their effectiveness in reducing tax evasion.

Tax laws regulate which expenses are deductible. Equally common is limiting deductible amounts to certain maximum amounts. Third, they looked at prefilling deductions on tax returns.

The results show that limiting tax evasion possibilities by disallowing the deduction of certain expenses is merely an ineffective instrument in combating tax evasion. Rather, a tax evasion-shift- effect is observed. Tax evasion through the overstatement of deductions is barely reduced, but only shifts from items that are no longer deductible to items that continue to be deductible.

Limiting the deductibility of expenses, on the other hand, avoids this tax evasion-shift-effect. Thus, limiting deductibility seems to be a quite effective instrument in fighting tax evasion.

Tax returns with prefilled deductions represent a relatively new method. For example, electronic tax return programs fill in the current tax return with the previous year's figures for initial guidance. Moreover, automatic data exchange between tax authorities and employers, social security institutions and banks can enable prefilling of tax returns (third party reporting).

Compared to blank forms, the study results suggest that prefilled deductions increase tax compliance considerably. In particular, the level of item-specific tax evasion decreases - especially for items that are favored for tax evasion. This result underlines the importance of non-monetary but psychological factors for the design of tax rules.

For political decision-makers, the prefilling of deductions in the tax return, as far as technically feasible, could therefore represent an effective method to reduce tax evasion, conclude Michael Overesch, Martin Fochmann, Tobias Kölle and Frank Hechtner. While limiting the deductibility of expenses requires democratic justification in each individual case, prefilling only requires a change in the administrative process and is essentially already performed by tax return software. More importantly, however, the disallowance or limitation of deductibility is a lump sum solution that also affects tax bills of honest taxpayers. Whereas prefilling does not have any of these negative consequences on honest taxpayers.