Abstract
We examine whether a taxpayer’s decision to choose a taxpayer-favorable (vs. a taxpayer-unfavorable) characterization of income is associated with contextual and individual dimensions of that decision. Using a 2 × 2 factorial experimental design, we manipulate the prevailing social norm on whether there is a general belief that a specific form of income should be characterized as a capital gain (taxed at a lower tax rate and hence taxpayer favorable) or as ordinary income (taxed at a higher tax rate and hence taxpayer unfavorable), and the group affiliation on whether the individual is making a tax characterization decision as a sole proprietor or as a member of a group practice. Moreover, we measure participants’ fairness perception of characterizing the income as capital gains versus ordinary. We study the decisions of 180 graduate business and accounting students from two US business schools to explore these dimensions using a tax-ambiguous income situation. Results indicate that both contextual and individual dimensions impact taxpayer decisions. Specifically, the social norm and fairness perception of characterizing income as capital gains affects the likelihood of choosing such a characterization. Being a sole proprietor or a member of a group practice does not have any significant main effect. However, relative to all other conditions, taxpayers are most likely to characterize income as capital gains when both the social norms are for capital gains characterization and when the taxpayer is a member of a group practice. Results remain largely robust to a variety of alternative explanations. We conclude the paper with a discussion of our findings and their implications for tax policy, enforcement, and research.
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Notes
Alm and Torgler (2011) characterize the tax compliance puzzle as the observed, higher level of compliance relative to what is optimal for the taxpayer based on the economics-of-crime model (Becker 1968). In contrast, McGee (2006) focuses on the act of tax noncompliance (i.e., tax evasion). In this study, we acknowledge that a decision that minimizes taxes (by characterizing income in a manner that will be taxed at a lower rate) is unfavorable to the collective tax system, and assumes that, from an economic benefit dimension, characterizing income in such a manner is favorable to the tax-paying entity. However, we do not make any claims along non-economic dimensions as to the favorableness, ethicality or fairness of such a decision to any of the stakeholders.
Of material importance is that of the $385 billion net tax gap (i.e., the difference between what should be paid and what is paid voluntarily and on time), $235 billion is attributable to individual taxpayers, and of that, $122 billion relates to business income and an additional $68 billion relates to non-business income (IRS 2012).
We recognize that tax fairness can be considered along alternative dimensions (e.g., Wenzel 2003). We interpret equity in trade and equity in burden as two dimensions subsumed in the single construct of outcome fairness, which is cleaner to operationalize and to isolate from other, extraneous effects (Cohen et al. 2007; Bierstaker et al. 2012; Kaplan et al. 2013).
Cialdini and Trost (1998) also discuss injunctive norms as broad societal expectations. We do not examine injunctive norms because we are interested in a tax-ambiguous situation where there is no normative, regular solution per se, but rather a set of plausible, legally acceptable alternatives. As such, the relevant construct of interest is a descriptive norm, which is more commonly activated in ambiguous situations. We acknowledge an anonymous reviewer for helping to clarify this distinction.
An implicit assumption is that the group prefers the capital gains characterization because it is tax-favored and, thus, beneficial to all members of the group, including the individual making the decision. Of note, group members, including the reporting individual, may not only be concerned about maximizing tax benefits, but also minimizing risks. We address the role of the individual’s risk aversion in the sensitivity analysis section of this study.
This view is consistent with the contingent factors model (Jones 1991) which suggests that the moral intensity characteristics of an issue itself impact individuals’ ethical decision making. Cohen and Bennie (2006) find that of six elements of moral intensity, the magnitude of harm and benefit consequences of an issue is the most important moral intensity element in all stages of ethical decision making.
We focus on the single construct of outcome fairness of a specific tax issue, acknowledging that the taxonomy of ‘tax fairness’ is multidimensional (e.g., Wenzel 2003). Some models, drawing from Schwartz (Schwarz 1977), find that providing general education that influences the fairness perceptions about a tax system, policies, and burden enhances compliance (e.g., White et al. 1990; Wartick 1994; Roberts 1994; Christensen et al. 1994). However, other taxonomies consider issue-specific elements of equity in trade (i.e., equity in tax-funded government benefits relative to taxes paid [equity in exchange]), equity in burden (i.e., equity in taxes paid relative to what economically-similar taxpayers pay [vertical equity]), and relative to economically-dissimilar taxpayers [horizontal equity] (e.g., Jackson and Milliron 1986).
This proposition is also consistent with equity theory, which suggests that individuals are motivated to maintain equity between the inputs they contribute and the outcomes they receive (Adams 1965). This presumes that taxpayers take a solely self-interest and/or economic cost-benefit approach to tax decisions. We purport that taxpayers also assess perceived fairness of a specific tax issue based on the moral intensity characteristics of the issue itself. Nevertheless, we address the possibility of the alternative explanation in the sensitivity analysis section.
While Bobek et al. (2013) measure perceived unfairness using six items that generally reference income situation, laws, group and systems their experiment examines a tax deduction issue. This may explain why only a grouping of three of the six items results in acceptable scale validity. Our perceived fairness measure specifically asks about the participants’ perception of the fairness of the capital gains characterization.
Participants were recruited from two schools and at two different time periods. Untabulated analysis of covariance results remain qualitatively similar when we add an indicator variable for one school (versus the other) or for the first (versus second) recruitment period. The contrast effects become only marginally significant when we conduct by-school or by-time period analyses (both p < 0.10).
One batch of students from one school was inadvertently not paid (50 students). Untabulated results remain qualitatively similar when we either add an indicator variable for paid (versus unpaid) participants or we drop the unpaid participants from the sample.
We consider each manipulation question’s pass rates to be within the range of pass rates (75–85 %) disclosed in experimental tax research published in top accounting journals in the last decade (1999–2011) including; Maroney et al. (2002), Alexander (2003), and Henderson and Kaplan (2005). The demographics for those passing and not passing the manipulation check questions were similar except that those not passing were marginally younger and had slightly less experience filing tax returns.
The alternative perspective is that participants may view the capital gains characterization as a risky proposition and focus on this as being more of a threat (and less of an opportunity), in which case they would be less likely to choose that tax characterization (Highhouse and Yuce 1996; Jackson and Hatfield 2005).
Interestingly, we find, in untabulated analysis, a significant effect for both the social norm and group affiliation variables when we interact each with the perceived fairness variable. This may be indicative of individuals rationalizing their choice to adhere to social norms and/or to follow their referent group under the guise of behaving consistent with their perceptions of fairness of the tax item at issue (Wenzel 2005; Blanthorne and Kaplan 2008). Also, as an anonymous reviewer suggested, this interaction could be the primary context where perceptions of fairness would be fully engendered.
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Appendices
Appendix 1
Example of Experimental Instrument [with alternate manipulations]
You [and nine partners] own a real estate operating company that owns and operates residential real estate property. You [The group] bought a five unit residential building with the intention of systematically renovating units while renting units not under renovation. When the building was completely renovated you [the group] intended to sell the unit.
Three years after acquiring the building you [the group] sold the building and realized a taxable gain of $150,000 [$1,500,000].
[You are responsible for preparing the group’s tax return in the year of sale.] You can choose to recognize the income from the sale as either capital gains or ordinary income.
If you recognize the income as capital gains you [each member of the group] will pay taxes on the sale in the amount of $22,500. When you file your [each member of the group files their] tax return your total tax bill [their total tax bill related to the group] will be less than you’ve [they’ve] already paid in tax and you’ll [they’ll] get a $40,000 refund when you file your tax return [in relation to the group’s activities]. Classifying the income in this way would be consistent with your prior filing practice when selling units you had managed for rental income.
If you recognize the income as ordinary you [each member of the group] will pay taxes on the sale in the amount of $52,500. When you file your [each member of the group files their tax return their] tax return your total tax bill [their total tax bill related to the group] will be less than [you’ve] they’ve already paid in tax and you’ll [they’ll] get a $10,000 refund when you file your tax return [in relation to the group’s activities]. Classifying the income in this way would be consistent with the manner in which property developers file when selling units they had acquired for renovation and resale.
You believe a large majority of taxpayers in your circumstances would recognize the income as capital gains [ordinary] income.
Appendix 2
Experimental Questions
For the following questions, please indicate by circling the number on the scale, which most closely represents your decision or belief. The closer you place a circle to the end points, the stronger you agree with the phrase at that end of the scale.
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Cohen, J., Manzon, G.B. & Zamora, V.L. Contextual and Individual Dimensions of Taxpayer Decision Making. J Bus Ethics 126, 631–647 (2015). https://doi.org/10.1007/s10551-013-1975-9
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DOI: https://doi.org/10.1007/s10551-013-1975-9