Tax Evasion and the Rule of Law in Latin America

Few tasks are as crucial for the future of democracy in Latin America—and, indeed, in other underdeveloped areas of the world—as strengthening the rule of law and reforming the system of taxation.

In this book, Marcelo Bergman shows how success in getting citizens to pay their taxes is related intimately to the social norms that undergird the rule of law. The threat of legal sanctions is itself insufficient to motivate compliance, he argues. That kind of deterrence works best when citizens already have other reasons to want to comply, based on their beliefs about what is fair and about how their fellow citizens are behaving. The problem of "free riding," which arises when cheaters can count on enough suckers to pay their taxes so they can avoid doing so and still benefit from the government’s supply of public goods, cannot be reversed just by stringent law, because the success of governmental enforcement ultimately depends on the social equilibrium that predominates in each country. Culture and state effectiveness are inherently linked.

Using a wealth of new data drawn from his own multidimensional research involving game theory, statistical models, surveys, and simulations, Bergman compares Argentina and Chile to show how, in two societies that otherwise share much in common, the differing traditions of rule of law explain why so many citizens evade paying taxes in Argentina—and why, in Chile, most citizens comply with the law. In the concluding chapter, he draws implications for public policy from the empirical findings and generalizes his argument to other societies in Africa, Asia, and Eastern Europe.

“Tax compliance lies at the core of the modern state, yet we don’t know very much about it. We know even less about compliance in developing countries, where tax systems face great demands with scarce resources. This admirable book fills the gap while making a significant contribution to our understanding of taxation and political development in Latin America.”—James E. Mahon, Williams College

“The pervasiveness of tax evasion in Latin America is often taken as a sign of institutional weakness and incomplete state formation. In this innovative and painstakingly researched book, Bergman argues instead that understanding tax evasion requires that we move beyond questions of institutional strength and state capacity to study what are in many ways more difficult questions of culture and norms. According to Bergman’s compelling argument, deep-seated cultural norms explain tax behavior better than the capacity of tax-collecting agencies or the severity of the penalties associated with tax evasion.”—Kent Eaton, University of California, Santa Cruz

“This is a major and innovative contribution to the crucial issue of taxation in Latin America. As the author makes clear, there will hardly be sustainable economic development and strong democracies without a solution to the manifold problems that plague taxation in this region. This book should have strong appeal for a wide range of disciplinary interests.”—Guillermo O’Donnell, University of Notre Dame

“This is a great study that provides a crucial criticism of the literature on the new institutionalism in political science. The author persuasively shows that the nature of the tax agency, or even the enforcement of rules sanctioning non-compliance, does not explain the behavior of taxpayers. . . . Others should follow in Bergman’s steps, extending this study to other policy areas and to other countries, but without losing the richness of his empirical analysis.”—Maria Victoria Murillo, Political Science Quarterly

“This is a powerful exemplar of how the movement away from simplistic ‘rational man’ models toward behavioral treatments can enrich an understanding of the economy.”—K. P. Jameson, Choice

“Bergman develops a very sophisticated argument solidly grounded in a variety of disciplines, from sociology to political science and economics. . . . [This] is an outstanding book, and it will be a key reference for anyone interested in taxation versus representation not only in the region but in other geographical areas. Indeed, I suspect that many readers in emerging markets will find that Bergman’s penetrating argument hits close to home.”—Luigi Manzetti, Latin American Politics and Society

“Bergman’s comparative research design is exemplary, and his book may be read with profit even by comparativists who do not study taxation or Latin America. It would be a good teaching text for a graduate seminar on research methods.”—Isaac William Martin, Perspectives on Politics

Marcelo Bergman is Associate Professor in the Department of Legal Studies at CIDE in Mexico City and the director of PESED (Program for the Study of Security and the Rule of Law). He has served as a consultant to tax administrations in Argentina, Chile, and Mexico.

Contents

List of Figures and Tables

Preface and Acknowledgments

Introduction

1. Compliance and Enforcement

2. Measuring Tax Compliance in Chile and Argentina

3. Taxpayers’ Perceptions of Government Enforcement

4. General Deterrence: Impunity and Sanctions in Taxation

5. Specific Deterrence and Its Effects on Individual Compliance

6. The Role of Trust, Reciprocity, and Solidarity in Tax Compliance

7. Social Mechanisms in Tax Evasion and Tax Compliance

Conclusion: Tax Compliance and the Law

Appendix A: On the Data

Appendix B: A Game Theory Approach to the Logic of Tax Compliance

Appendix C: A Simulative Game: The Effects of Enforcement

Appendix D: The State, the Law, and the Rule of Law

References

Index

Introduction

Why do states with similar tax systems have different rates of tax compliance? Why do the citizens of countries with equivalent levels of development, similar macroeconomic policies, and a shared cultural heritage show remarkable differences in their abidance to law and prescribed rules? This book explains why Chile has been more successful than Argentina in achieving compliance with taxes, and it presents a conceptual framework to account for disparities in law abidance and conformity to rules. In Tax Evasion and the Rule of Law in Latin America, I argue that countries with established rule-of-law traditions, where norms and rules are widely embraced, have better levels of tax compliance and are capable of developing sound fiscal policies. Conversely, countries whose citizens live on the margins of the law face great difficulties in reversing tax evasion, because they are unable to resolve basic collective-action problems. Countries that reach virtuous equilibria between government enforcement and social adherence to norms are better suited to enter a path of development.

Scholars in legal studies, political science, and sociology have studied the role of law in modern states, as well as the social and political benefits of the rule of law. This literature, however, has largely ignored the questions of how law becomes effective, under what conditions stable equilibria are reached, and what mechanisms enable optimal legal behavior. I contend that the effectiveness of law relies heavily on self-enforcement and voluntary compliance, and that citizens comply to the extent that they believe adherence to law represents the best alternative among different possible outcomes. By analyzing the institutionalization of tax behavior, I contribute to an explanation of how voluntary compliance emerges, survives, or fails. Approaching tax compliance from this perspective allows me to uncover many blind spots in traditional theories of voluntary compliance.

Tax evasion is just one of many individual acts that defy the ability of states to enforce enacted laws, and it is found everywhere. What distinguishes most developed countries from developing nations is the magnitude of noncompliance. For example, the value-added tax (VAT) compliance rate for OECD (Organization for Economic Cooperation and Development) countries is in the 70–85 percent range, compared to 45–77 percent for Latin America. But even in countries with similar levels of development, we find vast differences in tax-compliance levels. Chile and Argentina have similar tax structures and comparable tax rates and enforcement mechanisms, yet compliance has been far superior in Chile.

Taxpayers in Chile conform better to tax laws in part because they perceive their own tax authorities as more effective and legitimate than Argentines perceive theirs to be. Compliance, however, depends on more than an effective tax administration (TA). Tax evasion has cultural roots in social norms and institutional arrangements. I argue that deterrence is more effective in societies with better norm abidance, because government threats of law enforcement become more credible, thereby nurturing cooperative "compliance equilibria." In countries where norms are not widely upheld and where laws are consistently violated, on the other hand, citizens develop attitudes and beliefs that inhibit their compliance with rules, contributing to the formation of "noncompliance equilibria." The failure to develop a culture of conformity to norms biases individual perceptions and limits the effectiveness of government deterrence, leading taxpayers in noncompliant environments to defy government authorities; these taxpayers believe that noncooperation is rational behavior. In other words, where only suckers get taxed, it pays to cheat.

Because nobody likes to pay taxes, there is a need to study the social mechanisms that compel taxpayers to comply in certain environments and to cheat in others; there is also a need to inquire about why similar enforcement yields differences in rule conformance. These questions also have important implications beyond fiscal policies. Tax evasion inhibits the creation of healthy economies and sound paths for development. It is harder for states that fail to elicit high tax compliance to gain wide approval, because the quality of public goods in such states diminishes. Conversely, higher compliance is self-sustaining because it enables sound fiscal policies that promote improved consent.

This book is about cheaters, about suckers, and about legalists. Depending on the interplay of different variables, cheaters will predominate in one society and legalists in others. In the following pages I examine the motivations that lead people to cheat, comply with, or challenge the government in the field of taxes. It presents an in-depth analysis of a large set of data collected exclusively for this project over many years. It includes six new surveys on tax compliance, individual tax-return and tax-enforcement records on more than thirty thousand taxpayers, and an experimental laboratory study with college students in both Chile and Argentina. In order to study how social equilibria operate, the data-driven research on which this study is based evaluates, among other topics, the effect of government enforcement of tax law, the legitimacy of authorities, the scope of deterrence, and the role of culture.

This has larger implications that transcend the field of taxation. At stake is the study of states and societies that seek a clear path for development, for consolidation of democratic regimes, and for pacific resolutions of income distributions and social conflicts. The in-depth investigation of why similar policies and enforcement yield very different outcomes reveals the complexities of developing paths to stability and growth, or to unrest and stagnation.

This book sheds light on at least three central questions debated in the literature. First, how does path dependency operate to enhance or constrain the ability of governments to raise revenues? This is crucial for middle- and low-income nations to enter a development path. In this study, I provide the data and the quantitative approach to explain how culture and social learning affect compliance with laws, and why citizens’ compliance is crucial for sustainable growth. Second, this book provides additional insights regarding the nature of the relationship between democracy and taxation. Over the last decades many countries have proceeded on a different track compared to early modern nations such as Britain and the United States, where democracy and taxation developed hand in hand. Re-democratization in countries such as Argentina did not have a meaningful impact on citizen’s acquaintance to taxation, and social and political instability is tied to these broader processes. This book investigates the peculiar nature of taxation, which is not firmly grounded in representation and citizenship. Third, by going through the painstaking intricacies of citizens’ tax behavior, this study answers broader questions: how laws and institutional arrangements can effectively produce social and political change, under what set of conditions can change be brought about, and what are the limitations of legal entrepreneurship in social change. Although an all-encompassing answer to these questions is outside the scope of this book, I hope to provide a conceptual framework that articulates a preliminary answer to this puzzle.

<strong>Compliance and Evasion in Chile and Argentina</strong>

The Scope of the Problem

Although Argentina and Chile have similar levels of development, tax evasion differs markedly in the two nations. More than 85 percent of taxpayers in Argentina acknowledge that they cheated on their taxes during the previous year, and over 50 percent admit to failing to pay more than 20 percent of their legally owed taxes. In Chile, on the other hand, less than 20 percent of taxpayers admit to cheating on their taxes, and very rarely do they fail to pay less than 90 percent of their true tax dues. Income-tax noncompliance in Argentina exceeds 50 percent of legally expected revenues, and 35 to 50 percent of the expected revenue from the compliance-friendly VAT remains uncollected each year. Social security and payroll taxes fare even worse. In Chile, total noncompliance is estimated at less than 35 percent (Barra and Jorrat 1999), whereas the VAT-evasion rate averaged 22 percent in the 1990s.

Worldwide tax-evasion rates differ markedly. For most developed countries, VAT evasion averages 25 percent, whereas for developing nations it averages 48 percent. Data on the income tax, though incomplete, suggests that differences between developed and developing countries are even larger. For OECD nations, income tax-evasion rates range from 15 to 29 percent, whereas for Latin America income tax-noncompliance rates range from 29 to 75 percent. In this respect, Chile is considerably closer to the OECD standard, and the pattern in Argentina is more similar to that of the rest of Latin America.

Tax evasion in Argentina is a well-entrenched phenomenon. In contrast to Chile or the United States, where many taxpayers report cheating in small amounts, taxpayers in Argentina participate in bold, large-scale evasion schemes. In Argentina, evading taxes is not a peripheral activity or a way to make a quick extra buck but rather an institutionalized behavior and a source of revenue deemed legitimate by Argentine society. Chileans also try to maximize benefits and reduce their taxes, yet most taxpayers do so within the margins of the law. Some participate in tax evasion, but the majority of taxpayers who cheat do so marginally.

The magnitude of tax evasion affects national prosperity. Whereas the lost revenues in Argentina exceed US$45 billion per year (15 percent of GDP), in Chile the estimated lost revenues are US$4.7 billion a year (less than 7 percent of GDP). In recent years, the Argentine government has spent more on controlling tax evasion than on programs for fighting poverty and unemployment. In order to collect taxes, Argentina spends three times as much as Chile and over four times as much as the United States. The budget of the tax administration is twice as large as that of the education department and almost three times larger than that of the social-welfare department.

Legal and Political Context

Political instability and social conflict have dominated Argentina for many decades. From the 1930s to the 1980s, Argentina faced several institutional and social crises that generated a deep but subtle breach of trust in the political system; despite re-democratization in 1983, Argentines’ profound lack of faith in the government remains very much alive. The disenchantment with the country’s social, political, and economic institutions is a symptom of a broader social unrest. The inability of social institutions to manage the disastrous fiscal crisis of 2001 is intrinsically tied to this public disenchantment with government.

Chile has also been mired in political and social upheaval. A bloody 1973 coup ushered in a sixteen-year military dictatorship that disrupted more stable and pacific mechanisms for the resolution of social and political conflict. Setting aside this interval and a single episode of military rule in the 1920s, however, civilian rule and a proud legal tradition since the mid-nineteenth century have fostered political and judicial traditions in which law abidance and obedience to authority are predominant. As some scholars argue (Angell 2006; Valenzuela 1998), the military dictatorship was an aberration that did not entirely disrupt this pattern. The civilian legalist tradition has been easily recaptured and has yielded strong institutional performance. In fact, Chilean tax compliance was much higher during the 1990s than under the Pinochet dictatorship.

Compliance is a symptom of the strength of a country’s institutional legitimacy. Chile is one of the few Latin American countries where obedience to rules is widely upheld, authorities enjoy high levels of approval, and the rule of law is deeply rooted. On the other hand, the evasion of taxes is just one of many rule-breaking behaviors of the Argentines. Argentine noncompliance with many other laws clearly points to a state of anomie and social disintegration (Nino 1992). Subtly, and sometimes openly, the rule of law is challenged in everyday behaviors in Argentina (O’Donnell 1999). As we shall see, the difference in tax compliance between Chile and Argentina is tied to these broader differences of social and political context.

Case Selection

The study of compliance with law in general, and taxation in particular, requires a comparative perspective. There is little doubt that a deep understanding of the variables that affect compliance must take into consideration the social ecologies in which these laws operate. A central claim of this book—that the unit of analysis for tax behavior is not the individual’s self-motivation but the environment in which this individual operates—certainly calls for a comparative perspective.

Chile and Argentina are ideal cases for this study. The two countries have more in common with each other than either of them has with any other country in the world. That alone would make them very good comparative cases; a more important reason, however, is that through this research it is possible to identify the divergent effect that rules and institutions have on social and political outcomes in both countries.

Argentina is a representative example of a country that has fallen into the "noncompliance trap." Over the last century this country’s reversal of development (Waisman 1987) has puzzled social scientists, who have struggled to explain how such benign social and economic conditions (skilled workforce, homogeneous population, fertile farming land, abundant natural resources) were dilapidated. This country’s noncompliance is not of mere academic interest: it has a direct effect on the country’s inability to put its finances in order, and it partially accounts for the economic crisis (including devaluations, huge resource transferring, and freezing of bank deposits) that led to social violence, the resignation of presidents, and large waves of out-migration.

A comparative and empirical approach allows us to identify the legal institutions and cultural attributes that effect compliance, as well as social and political stability. This is why a successful case such as Chile is compared to a social trap such as Argentina. Chile has managed to avoid the noncompliance equilibria that are so common and devastating in the region. For Chile, the compliance equilibrium helps to explain why it has one of the most dynamic and stable economies in the area, and why a higher level of consensus and compromise (for the most part are absent in the region) characterizes its democratic institutions.

The divergent trend of Argentina and Chile illuminates processes and features that transcend both taxation and Latin America. This study tests hypotheses crucial for the socioeconomic and political outcomes in many countries around the world. Comparative research on these case studies is important because: (1) individual choices are greatly influenced by the environment, and therefore a systematic comparison of equilibria sheds light on individual outcomes; (2) Chile and Argentina are great representative examples of compliance and noncompliance equilibria; (3) these outcomes cause some of the most important differences between these countries; and (4) such a comparison sheds light on structural characteristics that affect development and social and political stability.

<strong>Perspectives on Tax Compliance</strong>

Scholars have approached tax compliance from a number of different perspectives and disciplines over the past four decades. Microeconomic theories of tax evasion claim that people pay taxes if their subjective perception of the likelihood of detection and punishment is higher than the cost of full compliance; such theories maintain that taxpayers’ calculations about the utility of taxation are only very rarely related to the actual provision of goods and services (Becker 1968; Cowell 1990). Numerous studies, however, have demonstrated that such an invariant assumption about taxpayers’ rationality does not fully capture the range of human motivations and aspirations (Tversky and Kahneman 1982; Elster 1989; Frey 1997). Deterrence theory has emerged as a valuable approach to account for differences in individual decision making. Its advocates point out that costs, benefits, and opportunities are subjectively perceived and should be evaluated accordingly. In particular, the actual effectiveness of the range of government enforcement tools is secondary to the way that this effectiveness is individually perceived; therefore, differences in compliance are tied both to culture and to actual enforcement of the law.

Sociologists and social psychologists have examined the effects of norms and culture on individuals’ tax behavior (Grasmick and Bursik 1990; Cialdini 1989; Lederman 2003) but have failed to show how these macro-structures produce micro-behaviors; these studies have ignored the interesting question of how individuals adopt or reject cultural norms in specific taxation situations.

Political scientists have addressed taxation and compliance in two dimensions. A sociopolitical perspective ties the capacity of governments to raise taxes to the "warrior state." A few recent studies use this perspective within the Latin American context (Centeno 2002; Lopez-Alvez 2000), and they help to successfully explain the emergence of a stronger state in Chile than in Argentina in the nineteenth century. More research is needed, however, to explain how nineteenth-century formations and institutions linger in the present. A second tradition has emphasized that modern states must develop strong political capacities to convey one of the central principles of taxation: equity. According to this perspective, people comply with taxation law to the extent that they receive tangible benefits from their contributions, fostering a working contract between citizens and rulers. If true, however, it is unclear how the free-riding paradigm was overcome in Chile. Even under a brutal dictatorship from 1973 to 1990, in which Chileans had no meaningful representation, no voice, and minimal provision of goods and services, Chile still enjoyed high levels of tax compliance compared to other countries of the region.

Without an interdisciplinary dialogue, the riddle of tax compliance will remain difficult to solve. In this book, I provide an institutional and interdisciplinary analysis of tax evasion. I follow Nobel laureate Douglas North’s general understanding of individual behavior in conceptualizing how taxpayers make compliance decisions. North writes: "Human behavior appears to be more complex than that embodied in the individual utility function of economists’ models. . . . People decipher the environment by processing information through preexisting mental constructs through which they understand the environment and solve the problems they confront. Both the computational abilities of the players and the complexity of the problems to be solved must be taken into account in understanding the issues" (1990, 20). Regarding the importance of the environment in shaping choices, North adds: "Uncertainties arise from incomplete information with respect to the behavior of other individuals in the process of human interaction. The computational limitations of the individual are determined by the capacity of the mind to process, organize, and utilize information. From this capacity taken in conjunction with the uncertainties involved in deciphering the environment, rules and procedures evolve to simplify the process. The consequent institutional framework, by structuring human interaction, limits the choice set of the actors" (25).

Using North’s understanding of individual behavior to extend the pure microeconomic perspective, I argue throughout Tax Evasion and the Rule of Law in Latin America that taxpayers’ decisions transcend the realm of profit maximization. Taxpayers do not purely optimize but rather mostly satisfy personal expectations (Simon 1999). Their decisions, however, are heavily determined by an evolutionary conceptualization of compliance and responsiveness to rules. Following sociological traditions, I argue that the way individuals perceive costs, obligations, duties, and social sanctions is critical for each compliance decision. Those perceptions evolve from a set of social interactions and structure individual strategic decisions (Coleman 1990). People maximize utilities inasmuch as they pay as little in taxes as they can. But the environment in which people operate fundamentally shapes how they frame the maximization of their benefits. In that sense, tax evasion depends more on the ecology of taxation than on the optimality of enforcement. Yet institutions do matter a great deal in this context, because they account for the formation of tastes and preferences. Political perspectives are instrumental to showing how states become effective in both generating an equity contract with taxpayers and producing enforcement to deter free riders from undermining the compliance game. Tax evasion, then, should be understood as highly sensitive to social, political, and cultural processes; any attempt to understand variation in tax evasion across cases must incorporate social, political, cultural, and economic perspectives on the problem.

<strong>Assumptions and a General Initial Hypothesis</strong>

I begin my analysis of tax noncompliance with three basic assumptions. First, I assume that nobody likes to pay taxes. Given the choice to free ride without being punished, most people would avoid paying taxes yet still benefit from public goods. This assumption, however, does not imply that most people cheat. Some do, and some do not. An analysis of tax compliance must consider the factors that enhance or constrain people’s decisions about whether to cheat.

My second assumption is that the distribution of risk-averse individuals and risk takers is similar across nations, except where a causal factor accounts for differences in the distribution. Thus, the starting unit of analysis ought to be the "tax environment." Tax compliance is exogenous, in the sense that external factors make taxpayers react to their perceptions of social and economic conditions in particular ways. Thus, analysis of the contextual world in which taxpayers operate, rather than of individual differences, better explains variance in tax compliance across countries. Variation within a country’s population does exist, of course; however, this within-country variance is random among different societies. The majority of research on tax evasion has been conducted from a within-country perspective. Such studies lack enough across-country variation to isolate causal explanations. A comparative approach illuminates an under-examined aspect of tax compliance behavior: the way that taxpayers come to perceive their tax environment successfully explains variation in tax compliance.

This leads to a third assumption, related to the self-sustaining nature of compliance. Tax decisions are tied to personal and ecological features, such as the routine of making tax decisions, the role of accountants as informants, and the makeup of the tax system. Within the constraints imposed by the tax structure and the filing system, taxpayer decisions become self-sustaining, resulting in an equilibrium that explains the stability of aggregate compliance rates. Nations rarely witness sudden shifts in overall compliance, because taxpayers rarely change their tax decisions from one year to the next. Rather, improvements in compliance are modest even when enforcement is stringent, because taxpayers are reluctant to alter tax practices unless they have substantial (generally firsthand) information that affects the prior equilibrium.

Most taxpayers are not sophisticated rationalizers who evaluate options and estimate risk levels thoroughly, then multiply these by the cost of punishment to arrive at optimal decisions. Rather, they decide using different value scales. Because taxpayers have access to only selective and limited information, they maximize benefits to themselves by relying on a complex set of variables that they can trust as good predictors of "safe" decisions. In a country whose citizens perceive that evasion goes unpunished, where the opportunities to cheat are large, and where the moral inhibitors against tax cheating are very low, we find higher levels of tax evasion. Therefore, I hypothesize that when there is room for individual tax decisions (i.e., controlling for the nature of tax system), taxpayers arrive at their best choices based on social learning, in which the perceived standardized behavior of peers and the previous levels of enforcement contribute to shape rules and norms that routinize most tax decisions. This is a path-dependent explanation of compliance based on culture, enforcement, and tax structures, all of which combine and operate in different scenarios to produce different outcomes. It is based on two general propositions: First, the higher the internalized level of enforcement of norms and rules, the more citizens will tend to comply with rules (including tax laws). Second, after these conditions are met, the friendlier the tax system is to compliance, the lower the level of tax evasion will be.

<strong>Key Analytical Tools for Explaining Differences in Tax Compliance and Law Abidance</strong>

My approach to understanding tax-compliance behavior relies on a particular understanding of voluntary compliance, the role of enforcement, and social mechanisms of decision making in taxation, which I briefly outline here. Chapter 1 will revisit and expand on the discussion introduced in this section.

Voluntary Compliance

Over the last few decades, economists, political scientists, and sociologists have demonstrated the virtues of cooperation to solve collective-action problems. In the realm of taxes, it has been stated that cooperation is attained through voluntary compliance. This does not imply that the threat of sanctions is absent but rather that enforcement is secondary to the free decision of taxpayers to report and pay their taxes without the threat of punishment. Margaret Levi has called this behavior "quasi-voluntary compliance": "It is voluntary because taxpayers choose to pay. It is quasi-voluntary because the noncompliant are subject to coercion—if they are caught" (1988, 52).

A central element of Levi’s argument is that voluntary compliance is a rational choice tied to individuals’ perceptions of fellow taxpayers’ behavior and to the responsiveness of government. Levi explains: "Taxpayers have confidence that (1) rulers will keep their bargains and (2) the other constituents will keep theirs. Taxpayers are strategic actors who will cooperate only when they can expect others to cooperate as well. The compliance of each depends on the compliance of others. No one prefers to be a sucker" (53). Levi’s analysis privileges the extracting capacities of authorities: "To minimize the costs of enforcement and to maximize the output that can be taxed, rulers have to create quasi-voluntary compliance. Quasi-voluntary compliance rests on reciprocity. It is a contingent strategy in which individual taxpayers are more likely to cooperate if they have reasonable expectation that both the rulers and other taxpayers are also cooperating. The key lies in what rulers and other government officials do to create mutual expectations of tax payments" (69).

In this argument, compliance is an assurance game wherein taxpayers end up believing that rulers will punish free riders and deliver goods and services. Taxpaying is tied to the equity or fairness of the system: rulers must convince taxpayers that the system is fair, that there is equity in taxation, and that the burden of taxpaying is shared. Levi’s pathbreaking perspective assumes that tax compliance is a cooperation game scheme in which taxpayers opt to engage in mutually advantageous exchanges to maximize utility. According to Scholz and Lubell (1998, 411), "Citizens will meet obligations to the collective despite the temptations to free-ride as long as they trust other citizens and political leaders to keep up their side of the social contract." Bo Rothstein (2005, 4) puts it plainly: "First . . . people [have to] believe that most others probably pay what they are supposed to, and second that most of the money is used for purposes people consider legitimate."

Will people always line up happily to pay their taxes if these two conditions are met? Probably not. In the United States, for example, although 99.1 percent of wages and salaries are reported to the IRS, sole proprietors report only 67.7 percent, and informal suppliers report only 18.6 percent (Bakija and Slemrod 2004). Free-riding temptations are apparently still strong within certain groups in a country where, according to many scholars, quasi-voluntary compliance should work.

Economists and tax administrators have always claimed that compliance lies in the power of the stick. Voluntary-compliance scholars like Levi and Scholz focus on fairness but overlook the social conditions that make enforcement effective. I propose to bridge the two perspectives by extending the voluntary-compliance approach, with some caveats. Compliance can be conceived as a cooperation game if we distinguish between two types of cooperators: active cooperators and passive cooperators. Conditional cooperators in the tax game belong to the second category, but they will actively seek the exit door if they become suckers, thereby becoming active defectors. This take on compliance has important implications for enforcement strategies. Passive cooperators are more concerned with the horizontal fairness of the system (that everybody pays their share and that there is no cheating) than with the equity of their payments. More important, enforcement is easier in compliance equilibria, where strategies are geared to convince passive cooperators that everybody else is playing the game fairly; in noncompliance equilibria, similar enforcement yields poorer results because suckers see cheaters everywhere, and therefore become active defectors.

Conditional (passive) cooperators expect the ruler first and foremost to punish free riders. But how do taxpayers know that the contract is being honored? More important, why are rulers able to coordinate conditional cooperation in one social setting while other rulers using the same repertoire of strategies in other contexts cannot attain similar results? In this book, I build on Levi’s argument about fairness and equity and apply it to the Latin American context. The chapters that follow will present additional proof of the validity of voluntary-compliance and contingent-consent propositions. States are indeed better off when they generate voluntary compliance, and good governance enables the extraction of revenues. More important, people are willing to pay their share of taxes, but this willingness is contingent on other taxpayers’ compliance, as well as on the rulers’ ability to deliver public goods as promised.

I depart from Levi, however, in several important ways. First, I propose that compliance and noncompliance equilibria are the most significant constraints on the ability of rulers to extract revenues and on the willingness of citizens to pay taxes. Second, I argue that such equilibria determine the type and viability of different enforcement strategies, which ultimately yield different outcomes. Third, I show by what mechanisms culture affects tax-compliance behavior by demonstrating the coevolution of enforcement and compliance culture. Finally, whereas for Levi and her followers the central unit of analysis is the ruler’s ability to raise revenues, I analyze the social and political arrangements that precondition citizens’ decisions to enter the quasi-automatic paths of either obeying or defying the laws. These arrangements have profound implications for both the creation of the rule of law and the spiraling declines of failing states.

The Role of Enforcement

Tax compliance rests on two principles: exchange (vertical) equity and horizontal fairness. Most studies of the subject have been devoted to considering how rulers can create the right institutions to enhance vertical equity and trust, but, surprisingly, much less energy has been directed toward understanding how rules can guarantee that cooperators are not being exploited (horizontal fairness). Better compliance can be ensured if states succeed in deterring passive cooperators from defecting in the tax game.

Taxpayers are more concerned to avoid being exploited by others than to secure the diffuse public goods that taxes produce. They will, for the most part, forego the benefits of exchange equity if they can successfully free ride. They will accept fate and passively cooperate, on the other hand, if compliance is the dominant social strategy. Understanding this should refocus our attention on states’ function from their role as institutions that deliver universal rights (Levi 1997; Scholz 2003; Steinmo 1993; Rothstein 2005) to their role as guarantors of cooperation. I do not underestimate the importance of exchange equity, but I believe that taxpayers are guided by fairness and impartiality first and foremost as they relate to not being exploited. Nothing unravels trust more quickly than the feeling of being a sucker, which creates a strong motive to defect. Thus, any tax-compliance analysis must consider whether a tax environment allows free riders to escape social and political sanction—that is, whether it is an environment of widespread impunity.

Scholars have largely overlooked enforcement because they have perceived it as a technical aspect of taxation. As I will demonstrate, however, enforcement is a key aspect of tax compliance, and it merits serious, in-depth research. Authors such as North (1990) and Fukuyama (2004) have shown that enforcement transcends the consolidation of bureaucratic capacities. Moreover, the assumption that tax evasion in some countries is high because tax-enforcement agencies’ are not technically skilled, or because these agencies are corrupt, is simply misguided. Argentina, for example, has invested more resources in combating tax evasion than has Chile; the Argentine tax-agency staff, management, and auditors are as capable as their Chilean and U.S. counterparts—and still tax evasion persists. Clearly, cheaters in Argentina thrive because tax evasion goes unpunished, but why has a good tax administration been unable to reverse cheating? Why is there greater horizontal fairness in Chile than in Argentina? Answers to these questions are to be found in the interplay among enforcement strategies and the type of social equilibrium found in a particular country. Enforcement is at the heart of the tax-compliance game because it elicits—or inhibits—the conditions for cooperation.

It is the subjectively perceived credibility of effective enforcement that compels citizens to abide by the rules. The threat of credible sanctions creates a virtuous circle because it both develops social and human capital and economizes on individual cost-driven decisions. Taxpayers who do not have to look for ways to evade taxes to be competitive in the marketplace can save in transaction costs and invest these resources in productive endeavors. The perception that rules are being enforced effectively reduces free riding and optimizes resource allocation, and more widespread tax compliance raises revenues and improves the quality of public goods.

In order to understand tax compliance, then, it is necessary to consider how taxpayers perceive enforcement, how their perceptions of the fairness and legitimacy of the tax system are formed, and how they process information. We need to proceed in redressing what North (2005) has recently identified as a lack of theory on learning, standards, and beliefs. This book theorizes about how the ecologies of taxation and the social environment affect individual learning and legal behavior in the tax field.

At the center of this book is a debate about how enforcement enhances compliance with laws. This question is relevant for thinking about how to deal with a wide range of social outcomes, such as informal economies and black markets, hiring practices, illegal immigration, environmental pollution, traffic violations, and trade in illegal substances. Enforcement needs to be studied by taking into account the distribution of compliance within a population, and the best strategies of enforcement should be formulated with the compliance (or noncompliance) culture of the affected population in mind. It is easier to ensure that rules will be widely obeyed in a law-abiding society; enforcement agencies have a strategic advantage in such societies because they target a comparatively small pool of cheaters. Hence, their enforcement measures cannot be successfully replicated in social settings where the scale of the problem is much larger and where cheaters have a strong incentive to imitate successful free riders. The split potential effect of enforcement calls for differentiated policy strategies: it may be feasible to expand tax laws and make them more complex in law-abiding societies, whereas minimal law should be pursued in noncompliant contexts.

The makeup of the equilibria explains why culture matters. "Culture" is defined here in very practical terms as the range of standard procedures, common beliefs, and shared values rooted and widely accepted within a community. A legalist culture is one in which the mandate of the law is usually embraced by the community, and in which people adopt strategic decisions with the functioning of legal institutions in mind (Friedman 1975, 1985). In a culture of compliance, most people adopt a disposition to comply with the law before undertaking any cost-benefit analysis. Of course, individuals can deviate from compliance if they realize that the costs vastly exceed the benefits. More important, not all members of a compliance culture behave in the same way. At times, existing subcultures are important to individuals, and these may be at odds with the larger culture. For our purposes, culture matters because people rely on it to help them guess their optimal strategies, thereby creating average behavior in equilibrium. In compliance climates, enforcement assures conditional cooperators that cheaters are being punished; therefore, a culture of compliance thrives. In noncompliance environments, by contrast, there are no conditions for cooperation. Enforcement is effective in compliance equilibria because it reproduces legal culture; it is usually ineffective in noncompliance equilibria because it can rarely reverse a nonlegal culture. Enforcement, therefore, is to some extent endogenous to the prevailing legal culture.

In failing states, laws and regulations are perceived as unenforceable, and they mostly do not deter disobedience. Under compliance equilibria, conversely, enforcement enhances general deterrence and contributes to the image of an efficient administration. Whether such a situation lasts depends, of course, on continuous improvement and the strategic decisions of state agencies. There are three initial elements that account for the effectiveness of enforcement.

First, successful enforcement depends on the scale or size of the problem. To the extent that norms and rules in the polity are largely upheld, the effect of enforcement is greater. When more people abide by norms, there is less need for monitoring and large watchdog organizations. Here, an additional marginal unit of enforcement yields bigger marginal units of compliance. Conversely, the larger the number of cheaters, the more difficult it is for regulators or enforcement agencies to achieve comparable results. Thus, a similar level, depth, and scope of enforcement measures might yield completely different results in different environments: in the first environment, moderate enforcement achieves reasonable compliance, whereas in the second, similar or even more extensive enforcement is inadequate for achieving greater law abidance.

Second, in compliance environments, enforcement is geared to limit free riding. In this sense, the role of the enforcer in compliant orders is to signal to passive cooperators that conditions for cooperation are being met. Here, to be a legalist pays off, because cheaters are more likely to be detected and punished; greater resources are allocated to generate more and better public goods, thereby enhancing a stronger sense of fairness. Moreover, when most people conform to costly laws, they have an incentive to ensure that other people are complying as well, fostering an environment in which horizontal, nonlegal enforcement (among peers) supports the vertical enforcement of the legal order.

Third, in noncompliance ecologies, enforcement must first generate the basic conditions of cooperation. Because there are so many free riders, the enforcer is always playing catch-up. In compliance equilibria, the role of the enforcer is containment; in noncompliance equilibria, the enforcer must wage an all-out war to transform the status quo. Comparable enforcement measures achieve better compliance results when the enforcer can select targets more efficiently.

Mechanisms of Taxation Decision Making

This book offers a set of sensible explanations to solve the riddle of tax-law noncompliance in many developing countries. I do not offer a comprehensive theory of enforcement and compliance, nor do I suggest a set of laws to predict outcomes. Rather, I present an empirically driven account of a two-country comparison that can shed light on many other cases. I contend that the appropriate approach to the study of tax compliance focuses on social mechanisms—that is, the set of causal patterns that enable explanations for how similar conditions produce disparate outcomes. Given that tax evasion has a strong cultural or ecological component that evolves from social, political, and economic conditions, there is a need to identify the processes that explain how people arrive at decisions that maximize their utilities in a context of bounded rationality. I focus on three such mechanisms: contagion effects, reciprocity for public goods, and the lasting endowment of effective enforcement.

Contagion—that is, the way that taxpayers rationally imitate the behavior of peers and other players—is the crucial first mechanism, because it explains how a critical mass of cheaters or legalists is formed and why changes in enforcement very rarely neutralize the powerful effects of imitation. When taxpayers learn that others cheat, they will be inclined to cheat; if they perceive that most taxpayers comply, they will be inclined to be legalists.

The second mechanism derives from the norm of reciprocity for the provision of public goods, which states that people tend to reciprocate for the allowances that they receive. Reciprocity in taxes, however, has not been well specified or convincingly tested. My results suggest that, far from being free riders, most individuals tend to cooperate when they receive allowances in return for their contributions. Whether the political system fairly redistributes tax revenues affects tax behavior, because when people receive public goods, they reciprocate with better compliance. Underlying this mechanism is a sense of vertical fairness. In addition, reciprocity operates horizontally: temptations to free ride can be overcome when individuals believe that other taxpayers are overcoming them.

The third mechanism is the lasting effect of enforcement. Individuals make choices based on default rules, which are heavily dictated by perceptions regarding the effect of sanctions, and they are strongly influenced by what they experience or learn from others regarding the effectiveness of tax-law enforcement. Both positive and negative experiences with enforcement have a lasting effect. Taxpayers caught cheating at an early stage assign higher detection capacity to their tax administrations than do those who are never caught. Effective enforcement has a strong evolutionary component, and it is particularly crucial that enforcement be strong at the outset or enactment of any law (I call this "norm-emerging enforcement"). To the extent that citizens perceive that the state is effective in curtailing free riders, they tend to obey the law. This has an enduring effect that allows the tax agency to concentrate its resources on fewer tax evaders, get good results from its enforcement, and reproduce its efficient image (I call this "norm-maintenance enforcement"). Whereas good, norm-emerging enforcement enhances a self-sustaining equilibrium of compliance, poor enforcement at earlier stages weakens the enforcement capacities of the norm, forging a noncompliance equilibrium.

The State and the Rule of Law

The erosion of the state’s enforcement capacities is a sign of its weakness. My analysis of tax behavior and of the ruler’s inability to curtail free riding sheds light on a broader problem: the weakness of the state and of the rule of law in Latin America. I do not attempt in this book to present a complete theory on this important topic. I do contribute to the understanding of state weakness, however, by providing a conceptual approach to ascertain the nature of certain institutional deficiencies. In appendix D, I provide some reflections that transcend the realm of taxes and consider legal failure in general, a key issue in contemporary Latin America.

The recent growing interest in the rule of law has centered on why rulers decide to abide by laws and not transgress the rules established between them and their subjects (Maravall and Przeworski 2003; Shapiro 1994; Weingast 1997). This is, however, an incomplete line of inquiry, because why rulers rule is no more important than why the ruled consent (Barzel 2002). There is no rule of law if people do not abide by the norms, and there is a latent trade-off between the legitimacy of the norm and the perceived sanctioning capacity of the enforcer. Both the carrot and the stick are needed, but the relative inverse importance of each will dictate the type of policy needed to ensure compliance.

As I will argue, the rule of law fosters environments of compliance where rational individuals have a predisposition to comply, because under these equilibria the payoffs of cooperation are perceived as higher from the inception. Compliance environments enable the promotion of fairness and citizenship, which are crucial for reproducing initial compliance equilibria. Therefore, under the rule of law, people perceive that they are more likely to maximize their benefits than they would be otherwise. Countries able to establish the rule of law are more successful in promoting passive cooperation than those that are not. I maintain that the establishment of the rule of law is a precondition for reducing tax evasion.

Given the limited effect of enforcement under noncompliance equilibria, I also argue that governments are better off when they enact a few enforceable taxes than when they enact a variety of taxes that are difficult to collect. Simplicity serves the tax administration. When tax evasion is high, the goal of government should be to reverse the equilibrium, because only a compliant environment produces steady, high revenues. The actions of governments in many underdeveloped countries have been precisely the opposite: to address mounting deficits, most Latin American states levy taxes that quickly became widely evaded, fostering a higher perception of noncompliance. Because populist governments incur larger social expenditures in noncompliance environments, it is more difficult for them to enable a compliance equilibrium. This produces a circular crisis of fiscal deficit, thus prompting the passage of more unenforceable laws. Conversely, minimalist states that are capable of enforcing a few important laws that can progressively address social demands under stable equilibria.

The rule of law depends ultimately on the strength of the state. I claim that we must transcend the narrow approach that conceives of states as a set of predatory rulers that successfully extract revenues from individuals in exchange for security and other services. This is more accurately a theory of government. In this book, the state is construed as set of organizations that operate under and are constrained by certain rules or institutions. In this sense, enforcement agencies are much more than a set of organizations with technical capabilities. Given the type of equilibria in which states operate, enforcement agencies affect the development of rules of law. Rulers in Argentina might want to raise more revenue through taxation and invest heavily in tax administration capacities, but the type of institutions in place constrain their ability to do so. In short, the rule of law depends on strong states, and strong states depend on the type of institutions that gave rise to them and shape them continuously. Successful states are those that, taking into account this path dependency, address enforcement strategies accordingly.

<strong>On Data and Method</strong>

Most studies of compliance in developing countries use aggregate indicators. Such data cannot successfully test individual behavior, nor can it identify the conditions and mechanisms that lead to decisions about law abidance. This book, by contrast, studies taxpayer behavior using individual data collected systematically for this purpose.

The empirical study of tax compliance is cumbersome because individual-level data is very difficult to collect. Most government agencies are reluctant or legally unable to allow research on individual tax returns. Even when such information becomes available, it is usually impossible to create data sets that also include individual tastes and preferences, which are needed to explain tax behavior. Therefore, most studies are based on aggregate data and self-reports, which present problems of validity and reliability.

In order to provide satisfactory answers to my research questions, I assembled a completely new database drawn from specially requested tax information and newly designed surveys. This data consists of six different surveys conducted in the late 1990s, four in Argentina and two in Chile. For each country, I conducted one survey among general taxpayers and another among the recently audited. In addition, for Argentina I conducted similar surveys with tax officials and tax auditors. The tax-return data I collected consists of the individual tax reports of fifteen thousand taxpayers from periods before and after enforcement measures were taken against them. These randomly selected cases have matching control groups. I also conducted an experimental study to test hypotheses about the effect of enforcement on both individual consent and the social mechanisms of compliance. I present further explanations of the data in appendix A.

The evidence in the chapters is usually presented very directly and clearly in the form of graphs and tables. I sacrifice in-depth statistical analysis in favor of simplicity, fluidity, and a less technical presentation. Only four simple, multivariate models are included; readers unfamiliar with regression analysis can skip them without missing the core of the argument. The broad evidence is compelling and speaks for itself.

Comparison in taxation is difficult because differences between countries and economies cause problems of interpretation, making multiple-variable models hard to evaluate. This study takes the logic of the most alike cases. As mentioned above, Chile and Argentina are very good candidates for a systematic comparative analysis, both in terms of their tax structure and their political and economic makeup.

<strong>Overview</strong>

The first and last chapters encompass broad conceptualizations of law abidance under adverse conditions. Chapter 1 develops the necessary theoretical repertoire for the rest of the book. I explain the merits of the two-equilibria approach, and I systematically discuss the role of enforcement in enhancing compliance through a model that integrates the role of culture, individual costs, and legitimacy. I further examine some of these ideas in appendix B, using simple game situations to explain the logic of my arguments. In appendix C, I use a simulative evolutionary game to explain the joint evolution of enforcement and compliance culture. I demonstrate that enforcement at the emergence stage of the norm, as well as the initial acceptance of the law, matters greatly in later rounds. This evolutionary approach shows that equilibria tend to stabilize under both noncompliance and compliance environments, and that the effect of recent individual enforcement is meager. Enforcement has a cumulative effect.

Chapter 2 presents a comparative empirical assessment of tax compliance in Argentina and Chile, including some glimpses at other countries. This chapter lays the groundwork for subsequent analysis by defining and measuring the dependent variable. I present estimates for the magnitude of tax evasion, and I develop a set of methods to assess voluntary compliance with the VAT for Argentina and Chile.

In chapters 3-7, I develop a detailed, evidence-driven analysis of tax compliance based on surveys, tax returns, and quasi-experimental data. Chapters 3, 4, and 5 examine the successes and limitations of enforcement efforts. I analyze data from surveys, courts, and individual tax returns, and I offer disaggregate and self-reported data on this subject for the first time. In chapter 3, I describe the similarities in the enforcement capacities of Chile and Argentina, and I demonstrate that the certainty of detection in the latter country is perceived as very weak, contributing to greater tax evasion and reinforcing a cycle of the permanent failure of tax reforms. Conversely, Chilean taxpayers believe that the tax administration has larger capabilities to detect significant tax evasion. It should be noted that tax-enforcement capacities are similar, although perceptions in both countries differ.

Chapter 4 examines the role of sanctions and their impact on tax evasion in an entire population—that is, their effectiveness as a form of general deterrence. For Argentina, I analyze the effects of penal-prosecution policies, concluding that the criminalization of tax evasion has had very limited results. In the case of Chile, I analyze administrative sanctions and show that they are much more effective in enhancing voluntary compliance. For both countries, I present self-reported data regarding individual assessments of the perceived severity of punishment for tax fraud, and I address problems of institutional coordination. I conclude that the key for effective sanctions is the high probability of their imposition. Impunity is perceived as very high in Argentina, leading to high tax evasion.

Chapter 5 undertakes an empirical analysis of individual tax-return data to answer the question of how enforcement affects post-enforcement tax decisions—that is, the effectiveness of enforcement as a form of specific deterrence. I examine the effects of three measures: audits, closure of businesses, and invoicing requirements. The effect of individual enforcement in eliciting future individual compliance is meager in Chile and totally ineffective in Argentina. I conclude that deterrence becomes a tautology: reforms fail because detection of evasion is weak, and detection of evasion is weak because enforcement lags behind noncompliance. Taken together, chapters 3, 4, and 5 demonstrate that enforcement yields better results in promoting general deterrence than particular deterrence does, because taxpayers under compliance equilibria believe that cheaters are more likely to be caught—cheaters, rooted in noncompliance practices, very rarely change.

Chapter 6 turns to an investigation of the role of culture and social norms in eliciting compliance behavior. I analyze the role of trust, reciprocity, moral obligation, and duty—as well as the role of inhibitors such as shame and guilt—in the formation of subjective perceptions of the effectiveness of detection and punishment for tax fraud. I pay particular attention to the process of information gathering. I stress the need to provide a culturally contextualized explanation of the way that societies come to recognize the significance of compliance in social cooperative endeavors.

Chapter 7 presents the results of an experiment conducted with students in both countries to evaluate the effect of social and economic variables on compliance. I describe the basic mechanisms that account for differences in individual compliance. This evidence allows me to speculate on how preferences are formed in relation to tax evasion.

The final chapter summarizes the arguments and extends them into guiding principles for policy prescriptions. These concluding remarks have broader implications for the study of law, politics, and the successful emergence of compliance environments. Along those same lines, appendix D examines the conditions for the establishment of the rule of law, represented by the lively image of compliance equilibria.

Latin American Studies

           Political Science

           Sociology

Law

Political Science

           Comparative Politics