Feld, Lars P.; Frey, Bruno S.

Working Paper
Tax Compliance as the Result of a Psychological Tax
Contract: The Role of Incentives and Responsive
Regulation

CREMA Working Paper, No. 2006-10

Provided in Cooperation with:

Suggested Citation: Feld, Lars P.; Frey, Bruno S. (2006) : Tax Compliance as the Result of a
Psychological Tax Contract: The Role of Incentives and Responsive Regulation, CREMA Working
Paper, No. 2006-10, Center for Research in Economics, Management and the Arts (CREMA), Basel

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 CREMA
Center for Research in Economics, Management and the Arts

Tax Compliance as the Result of a

Lars P. Feld
Bruno S. Frey

Working Paper No. 2006 - 10

CREMA Gellertstrasse 24 CH - 4052 Basel www.crema-research.ch

by

Lars P. Feld
University of Marburg
and
Bruno S. Frey∗
University of Zurich

Abstract

In this paper, we develop the concept of a psychological tax contract that goes beyond the
traditional deterrence model and explains tax morale as a complicated interaction between
taxpayers and the government. Based on crowding theory, the impact of deterrence and re-
wards on tax morale is discussed. As a contractual relationship implies duties and rights for
each contract partner, sticking to the fiscal exchange paradigm between citizens and the state
increases tax compliance. Citizens are willing to honestly declare income even if they do not
receive a full public good equivalent to their tax payments as long as the political process is
perceived to be fair and legitimate. At the procedural level, a friendly treatment of taxpayers
by the tax office in auditing processes increases tax compliance.

Keywords: Tax Compliance, Positive and Negative Incentives, Responsive Regulation.

JEL Classification: H26, H73, D73, D78.

This version: March 31, 2006.

∗ Lars P. Feld (corresponding author) is Professor of Public Finance at the University of Marburg, Department
of Public Finance, Am Plan 2, D-35037 Marburg (Lahn), Germany, Tel.: +49 6421 28 21702, E-mail:
[email protected]; Bruno S. Frey is Professor of Economics at the Institute of Empirical Research
in Economics, University of Zurich, Bluemlisalpstrasse 10, CH-8006 Zurich, Switzerland, Tel.: +41 634
3730, Fax.: +41 634 4907, E-mail: [email protected]. – We would like to thank four anonymous referees
and the editor of this special issue Val Braithwaite for very useful suggestions for revision.

31.03.06
 –2–

1 Introduction

The puzzle of the economic theory of tax compliance is why people pay taxes. According to

Allingham & Sandmo (1972), based on Becker’s (1968) economic theory of crime, the extent

of deterrence, as the product of the probability of being detected and the size of the fine im-

posed, determines the amount of income evaded. However, in view of the low deterrence ap-

plied in most countries, either because of a low intensity of control or small penalties, taxpay-

ers should evade more than they actually do, i.e. compliance is too high (Alm, McClelland &

Schulze 1992). In defense of the deterrence model, some scholars contend that the gap be-

tween theory and evidence might be closed by assuming sufficiently high risk aversion of

taxpayers. This is not convincing as the risk aversion that is needed in order to raise compati-

bility with actual compliance rates is not supported by evidence from the U.S. (Graetz &

Wilde 1985; Alm, McClelland & Schulze 1992) and Switzerland (Pommerehne & Frey 1992).

Two strands of arguments are brought forward in order to close the gap between theory and

facts (see the surveys by Andreoni, Erard & Feinstein 1998; Slemrod & Yitzhaki 2002; Tor-

gler 2003). One line of thought extends on the risk aversion theme and argues that the prob-

ability of being detected is subjective such that individual perceptions of being caught when

cheating on the tax code are much higher than objective probabilities of detection. While in-

dividual misperception of risk is unsustainable over a longer time horizon as people can infer

control intensities from friends and relatives, subjective probabilities of being caught exist in

the sense that the individual ability to evade taxes varies among subgroups of the population.

For example, withholding taxes strongly reduce auditing costs of tax administrations because

auditing of firms suffices to obtain information on employees’ labor incomes. It can also be

conjectured that incomes generated in the industrial sector can be less easily evaded than

those in the services sector, that capital income is more easily evaded than labor income and

so on. Adding socio-demographic structure is fully in line with the traditional tax compliance
 –3–

model that only abstracts from such variables for analytical convenience in order to focus on

the main economic arguments. Empirical analyses necessarily have to control for socio-

demographic variables in order to be more realistic. However, the empirical evidence implies

that the standard economic model augmented by socio-demographic control variables is not

able to explain the extent of tax compliance in a satisfactory way (Frey & Feld 2002).

A much more fundamental critique of the standard economic approach is provided by another

line of research according to which tax morale serves as an explanation for compliance rates.1

Frey & Feld (2002) argue that tax compliance is driven by a psychological tax contract be-

tween citizens and tax authorities. For that contract to be upheld, incentives like rewards or

punishment need to be provided, but loyalties and emotional ties that go well beyond transac-

tional exchanges must be considered additionally. These bonds between taxpayers and the

state provide for the core of individual tax morale and thus positively affect tax compliance.

However, as tax morale interacts with incentives, no simple tax policy guidelines can be pro-

posed. In the approach of Allingham & Sandmo (1972), tax morale explains the level of tax

compliance only residually and independent from tax policy and the behavior of state authori-

ties which is consistent with the view that fundamental social norms, like religion or civic

duty, but also individual attitudes, beliefs and intents to act shape tax morale. In contrast to

these supposedly policy-independent norms, the psychological tax contract is influenced by

government policy, tax authorities’ behavior and state institutions. Tax morale becomes en-

dogenous instead of serving as a residual explanation.

In this paper, we undertake first steps to develop the notion of a psychological tax contract as

a concept that, first, goes beyond the traditional deterrence model (fear in Scholz’ and Pin-

ney’s 1995 terms) and, second, explains tax morale (duty in their terms) as a complicated in-

teraction between taxpayers and the government establishing a fair, reciprocal exchange that

involves giving and taking of both parties. In Section 2, the theoretical basis of the psycho-
 –4–

logical tax contract is provided by discussing the interactions between incentives and the in-

trinsic motivation to pay taxes (Frey 1997). Positive (rewards) or negative incentives (deter-

rence) play a role, but it cannot be taken for granted that they induce tax compliance because

they may also crowd out tax morale. Thoughts on the impact of deterrence (Section 3) and

rewards (Section 4) on tax compliance highlights the importance of a differentiated approach.

A contractual relationship implies duties and rights for each contract partner. This is looked at

from an exchange perspective (Section 5) according to which the government should provide

public services to citizens in exchange for their tax payments. If the benefit principle of taxa-

tion, that implies a fiscal equivalence between public goods and tax prices, is violated by set-

ting those prices too high, citizens think they have a justification for evading taxes.2 However,

citizens may perceive their tax payments as contributions to the ‘bonum commune’ such that

they are willing to honestly declare their income even if they do not receive a full public good

equivalent to their tax payments. Income redistribution is the more accepted by affluent citi-

zens the more the political process is perceived to be fair and the more policy outcomes are

legitimate: The psychological tax contract has elements of gain (or distributive justice) and

participation (or procedural justice).3

The contractual relationship has additional implications at the procedural level (Section 6): the

way the tax office treats taxpayers in auditing processes plays a role. As Frey & Feld (2002)

and Feld & Frey (2002, 2002a) argue, the psychological tax contract presupposes that taxpay-

ers and the tax authority treat each other like partners, i.e. with mutual respect and honesty. If

tax administrations instead treat taxpayers as inferiors in a hierarchical relationship, the psy-

chological tax contract is violated and citizens have good reason not to stick to their part of

the contract and evade taxes. The psychological tax contract has thus also elements of respect

(or interactional justice). In Section 7, we draw some conclusions as to the policy implications

of such a contractual view of tax compliance. It implies that simple policy proposals are in-
 –5–

adequate to shape the psychological tax contract successfully. The right mixture of incentives

and a respectful treatment of taxpayers by tax officials needs to be found.

2 The Psychological Tax Contract

Nobody likes paying taxes, not least because it involves a public good and there are incentives

to free ride. Therefore, incentives are needed to enforce taxation. This is the central insight of

Allingham and Sandmo’s (1972) deterrence approach to tax evasion. However, several schol-

ars have established that selfish individuals would be rational not to pay taxes, because the

probability of being detected and the size of the fines in many countries are so low that it is

advantageous to evade.4 Tax payment is taken to be a ‘quasi-voluntary’ act (see Levi 1988)

and the tax authority must acknowledge that external interventions in the form of rewards or

sanctions may crowd out that intrinsic motivation to pay taxes. The idea of intrinsic motiva-

tion is largely attached to psychology. A group of cognitive social psychologists have identi-

fied that, under particular conditions, monetary (external) rewards undermine intrinsic moti-

vation.5 Giving of rewards for undertaking an activity has indirect negative consequences as

rewards lead to the expectation of future rewards such that desired behavior is undertaken

only if rewards are provided. Frey (1997) generalizes this basic idea in three ways:

(a) All types of external interventions may negatively affect intrinsic motivation, i.e. not only

offering rewards but also issuing commands, imposing rules and regulations as well as

punishments. Thus, deterrence imposed by the tax authority, may undermine individuals’

intrinsic willingness to conform to tax laws.

(b) The intrinsic motivation affected by external intervention is broadly conceived. It com-

prises actions undertaken for their own sake, i.e. without expectation of external reward,

as well as internalized norm guided behavior. The latter is the relevant concept as far as

taxpaying is concerned.
 –6–

(c) External interventions undermine intrinsic motivation when they are perceived to be in-

trusive by the individuals concerned (‘crowding out effect’), and they maintain or raise

intrinsic motivation when they are perceived to be supportive. The underlying psycho-

logical processes depend on how self-determination and self-esteem are affected (Deci &

Ryan 1985; Deci & Flaste 1995). Tax audits as intrusion by tax authorities can undermine

tax morale more strongly if the taxpayers’ sense of self-determination is high.

Tax officials are assumed to be aware of the effects on taxpayers’ behavior suggested by

crowding theory. They know that a disrespectful treatment of taxpayers undermines their tax

morale and therewith increases the cost of raising taxes. Tax authorities will only behave in a

respectful way towards taxpayers when there is a substantial extent of tax morale to begin

with. Tax officials are at the same time well aware that tax payments do not solely depend on

tax morale but that extrinsic incentives play a major role. In particular, incentives are used to

prevent taxpayers with low or lacking tax morale from exploiting the more honest taxpayers

and to escape paying their due share. A combination of respectful treatment and incentives is

possible and widely practiced. The sole reliance on incentives, as suggested by a large part of

the tax compliance literature based on subjective expected utility maximization, represents a

special case which only applies under restrictive conditions. Such a special case occurs when

the tax officials are convinced that individuals’ tax morale is low or does not exist at all. In

general, however, it is optimal to simultaneously use both respectful treatment as well as in-

centives. The higher the initial level of tax morale, and the stronger the crowding effect, the

less weight is put on incentives, and the more respectfully taxpayers are treated.

This relationship between taxpayers and tax authorities can be modeled as an implicit or rela-

tional contract (Akerlof 1982) which involves strong emotional ties and loyalties. Social psy-

chologists (Schein 1965; Rousseau & McLean Parks 1993) have been using this concept for a

long time, calling it a ‘psychological’ contract to set it clearly apart from formal contracts,
 –7–

which are obeyed because the parties respond to the explicit and material sanctions previously

agreed upon. Osterloh & Frey (2000), e.g., use psychological contracts to successfully analyze

the organization of firms. They could also be used in tax compliance analysis suggesting that

incentives and respectful treatment are important determinants of tax compliance.

In the psychological tax contract, punishment still plays a role in order to provide deterrence.

But the satisfaction of taxpayers with what they get from the other contract party, i.e. the gov-

ernment, mainly influences their tax morale. Taxpayers’ reward from that contract must be

understood in a broad sense going beyond pure exchanges of goods and services for the pay-

ment of a tax price. In addition to such direct exchange components, the fairness of the proce-

dures leading to particular political outcomes as well as the way the government and the tax-

payers treat each other are part of the contractual relationship. A genuine reward is therefore

obtained only if taxpayers as citizens have an inclusive, respectful relationship with the com-

munity. Both sides of the contract perceive each other as contract partners and treat each other

with mutual respect. As deterrence and tax morale interact, it would be counterproductive to

solely rely on punishment or monetary (non-authentic) rewards because tax morale can be

undermined. A dynamic relationship results in which deterrence, monetary rewards, fiscal

exchange, but also decision-making procedures and the treatment of taxpayers play a role.

The contractual metaphor has many advantages over traditional theoretical approaches. It first

underlines that paying taxes is a quasi-voluntary act. Each party has to agree to the contents of

the contract. In practice, it is seldom the case that each public good is individually contracted

with each taxpayer for a certain tax price. However, a steady reduction in tax compliance need

not only be interpreted as a violation of the law, but also as taxpayers’ discontent with what

they receive for their taxes. Second the contractual approach emphasizes the role of fair pro-

cedures decided upon at a constitutional stage. Tyler (1990) argues that people comply with

the law in general if they perceive the process as fair that leads to this law. Most obviously, it
 –8–

will be difficult to think of a psychological tax contract in autocratic regimes. The inclusive-

ness of political decision-making could however also be very different in democratic regimes

depending on the extent of citizens’ involvement in political decision-making. This second

advantage of the contractual metaphor stems from its potential to include notions of proce-

dural fairness almost by construction. Third, the way people are treated by the tax authorities

affects cooperation levels. Again the analogy to private contracts is useful. If you can pur-

chase a product from two different suppliers, would you choose that who is more friendly and

respectfully treating his customers? For sure, if the price differential is not too high. In a simi-

lar fashion, the way the tax office treats taxpayers plays a role.

At this procedural level, respectful treatment can be split into two different components. First,

the procedures used by auditors in their contact with taxpayers are to be transparent and clear.

In the case of arbitrary procedures, taxpayers feel helpless and get the impression that they are

not taken seriously. Such behavior reduces their perception of being obliged to pay taxes.

Second, respectful treatment has a direct personal component in the sense of how the person-

ality of taxpayers is respected by tax officials. If they treat taxpayers as partners in a psycho-

logical tax contract, instead of inferiors in a hierarchical relationship, taxpayers have incen-

tives to pay taxes honestly. In addition, respectful treatment of taxpayers enforces the effects

of emotions on compliance behavior. Grasmick & Bursik (1990) show for example that

shame affects tax compliance. Makkai & Braithwaite (1994) report similar evidence on the

impact of avoidance of humiliation on compliance with nursing home regulation.

Two opposite cases of treating taxpayers can be distinguished: (1) a respectful treatment sup-

porting, and possibly raising, tax morale; (2) an authoritarian treatment undermining tax mo-

rale. The tax officials can choose between these extremes in many different ways. For in-

stance, when they detect an error in the tax declaration, they can suspect an intent to cheat,

and impose legal sanctions. Alternatively, the tax officials may give the taxpayers the benefit
 –9–

of a doubt and inquire about the reason for the error. If the taxpayer in question indeed did not

intend to cheat but simply made a mistake, he or she will most likely be offended by the dis-

respectful treatment of the tax authority. The feeling of being controlled in a negative way,

and being suspected of tax cheating, tends to crowd out the intrinsic motivation to act as an

honorable taxpayer and, as a consequence, tax morale will fall. In contrast, if the tax official

makes an effort to locate the reason for the error by contacting the taxpayer in an friendly

way, the taxpayer will appreciate this respectful treatment and tax morale will be upheld.

3 The Impact of Deterrence on Tax Compliance

Given the requirements of a psychological tax contract, what role does deterrence play? Ac-

cording to the surveys by Andreoni, Erard & Feinstein (1998) and Slemrod & Yitzhaki

(2002), an overwhelming majority of theoretical studies predicts a positive impact of deter-

rence on tax evasion. The higher the fines, the lower is tax evasion – ceteris paribus; the

higher is the intensity of control, the lower is tax evasion – ceteris paribus. However, the em-

pirical evidence looks less convincing. For example, Dubin, Graetz & Wilde (1987), Dubin &

Wilde (1988), Beron, Tauchen & Witte (1992) and Slemrod, Blumenthal & Christian (2001)

find a significant positive impact of the probability of detection on tax evasion at least for

some income groups. While Schwartz & Orleans (1967), Friedland, Maital & Rutenberg

(1978), Klepper & Nagin (1989), De Juan, Lasheras & Mayo (1994), Alm, Sanchez & De

Juan (1995), Blackwell (2002) report a positive impact of fines on tax compliance, Spicer &

Lundstedt (1976), Friedland (1982), Elffers, Weigel & Hessing (1987) and Varma & Doob

(1998) present ambiguous evidence. Scholz & Lubell (2001) even find a crowding out of tax

compliance when penalties are introduced. Feld & Frey (2002) provide support for the am-

biguous impact of deterrence on tax compliance. For a panel of Swiss cantons, they find that a

higher intensity of control increases tax evasion while fines and penalties reduce tax evasion.

Similar contradictory evidence is found in other fields of regulation. Makkai and Braithwaite
 – 10 –

(1994) provide an evaluation of nursing home regulation and inspection and report that in-

spection teams that used purely negative and punitive approaches increased non-compliance.

The results provided by Sirakaya and Uysal (1997) on compliance with eco-tourism guide-

lines and by He (2005) on compliance with a discriminatory license requirement in Beijing

indicate that deterrence plays little role.

This mixed evidence can occur for many different reasons starting from measurements errors

in the empirical analysis, to a social sanctions approach of deterrence (Ekland-Olson, Lieb

and Zurcher 1984) and the impact of personal and social norms as moderators of deterrence

(Wenzel 2004). It can however also be explained on the basis of crowding theory. Higher con-

trol intensities increase deterrence and thus tax compliance on the one hand, but may be per-

ceived as intrusive by taxpayers and thus reduce tax compliance on the other hand (Scholz

and Pinney 1995; Kirchler 1999). Feld and Frey (2002) provide evidence that fines and penal-

ties are part of a non-linear punishment schedule that allows for low levels of fines in the case

of minor offenses against the tax code, even a standing tax amnesty in the case of self-

denunciation, in order to reduce taxpayers perception of intrusiveness, but requires high pen-

alties in cases of tax fraud or major convictions in order to make clear that the psychological

tax contract is at stake. Put differently, nobody is perfect, and to cheat a little bit on taxes is a

common and minor human weakness, and should be considered as such, while basic viola-

tions of the tax code undermine the basic contractual relationship between citizens and the

state and must therefore be punished more heavily. Minor and major offenses could thereby

be distinguished with respect to the amount evaded, but also to procedural categories, for ex-

ample by differentiating between active tax fraud by manipulation of the balance sheet and

passive tax evasion when taxpayers forget to report particular income components.

Deterrence has thus two different aspects. On the one hand, in order to keep up a psychologi-

cal tax contract between the tax office and the taxpayers, honest taxpayers must be confident
 – 11 –

that they are not exploited by dishonest tax cheaters. Thus, deterrence for major violations of

the tax code reduces tax evasion. On the other hand, each taxpayer may make a mistake, so

that minor offenses can be penalized less without undermining the psychological tax contract.

A non-linear punishment schedule with low fines for minor tax evasion and high penalties for

tax fraud, will serve the purpose of shaping tax morale. All in all, the evidence suggests that

an exclusive reliance on deterrence is not a reasonable strategy to increase tax compliance.

4 Rewarding Taxpayers

In contrast to the standard model of tax evasion which raises the relative cost of not paying

taxes, rewards raise the benefits of paying taxes. A reward given to taxpayers for correctly

fulfilling their duties changes the relative prices in favor of paying taxes, and against evading

them (Falkinger & Walther 1991). For this result to obtain, two conditions must be met:

(1) The income effect induced by the higher wealth position must not work in the opposite

direction. But this is unlikely if the reward is small compared to the tax liability so that

the income effect also tends to be small. Moreover, there is little reason to expect that

higher wealth should induce more, rather than less, tax evasion.

(2) The reward may induce strategic behavior by the taxpayers if it depends on the reduc-

tion of evasive behavior. In that case it may be rational to first increase tax evasion and

thereafter reduce it in order to benefit from the rewards offered. As the rewards consid-

ered here depend on being a “good” taxpayer, strategic behavior is not a rational option.

It is crucial to consider effects of rewards on behavior going beyond those analyzed by stan-

dard theory. From the perspective of crowding theory, receiving certain types of rewards may

undermine the intrinsic motivation to pay taxes. The more rewards are perceived as an ac-

knowledgment for being a good taxpayer, the more they are perceived as supporting and tend

to bolster and raise tax morale quite in contrast to deterrence. This motivational effect then
 – 12 –

works in the same direction as the relative price effect, and strengthens the attractiveness of

giving rewards to “good” taxpayers. In the case of the normally applied punishment for failing

to pay the taxes due, the relative price effect and the motivational crowding-out effect work in

opposite directions. The way rewards are handed out to “good” taxpayers is thus essential for

its effects on taxpayer behavior.

The reward may take the form of a direct monetary payment. It may be proportional to the

size of the tax payment (i.e. a percentage rebate), or in the other extreme may take the same

size for all “good” taxpayers. The relative price effect is larger in the first case, but this bene-

ficial effect may easily be overcompensated by a crowding-out effect. A reward received in

the same monetary dimension as the tax payments is likely to be discounted by the taxpayers

as a “right”, and then does not positively influence tax morale. In contrast, a reward on pur-

pose distinguished from the taxes due tends to be perceived as a sign of acknowledgment. If

this is indeed the case, it is even better to give the reward in non-monetary form. To provide

“good” taxpayers with better and less costly access to public services is likely to raise tax mo-

rale more strongly than money. Such a “gift” also emphasizes the exchange relationship be-

tween the taxpayer and the state based on reciprocity (Fehr, Gächter & Kirchsteiger 1997).

There are many possibilities to reward “good” taxpayers in these terms. For instance, they can

be offered free entry to museums, exhibitions and other cultural activities undertaken by the

state. Or they can be given a reduction (say, 50%) on all public transport. Most taxpayers re-

ceiving a reward in these terms take it as a sign of appreciation rather than simply a reduction

in taxes (which would quickly be taken as a matter of course).

It is well known from psychological research that punishment and rewards lead to different

behavioral outcomes. Indeed, it appears to be common knowledge among psychologists that

rewards lead to better outcomes than punishment. Already Skinner (1948, 1953) emphasized

the importance of positive incentives. In the literature on social loafing (see Diehl & Stroebe
 – 13 –

1987; Witte 1989), the impact of reward and punishment are emphasized and it is shown that

rewards particularly help to solve the problem of “hiding in the crowd” (Davis 1969). George

(1995) provides additional quasi-experimental evidence that rewards and punishment differ-

ently affect social loafing and significantly so. In addition, research on the effects of leader

reward and punishment behavior in organizational psychology suggests asymmetrical behav-

ioral responses to rewards and punishments (Sims 1980).

5 Tax Compliance and Social Exchange

From the perspective of a standard economic theory, a much more direct incentive for tax

compliance than deterrence or rewards consists in the goods and services that the state pro-

vides to citizens in exchange for their tax payments (Mackscheidt 1984, Smith and Stalans

1991). If the analogy to private contracts is considered, the goods or services purchased pro-

vide the foremost incentives to pay the price for these goods and services. The incentives

from private law to stick to the duties fixed by the contract mainly serve as an insurance if the

individuals’ desire to get a product is insufficient or the conditions for a do ut des are unfa-

vorable. Similarly, rewards in the form of gifts for loyal customers serve as a positive means

to bind them. Because the state supposedly provides public goods, services and infrastructure,

which are not necessarily traded in private markets, or redistributes income and wealth, the

fiscal exchange relationship poses additional difficulties.

From the perspective of a psychological tax contract, respectful treatment occurs at two dif-

ferent levels of action, the fiscal exchange and the procedural level. The fiscal exchange be-

tween the state and its citizens requires that citizens’ tax payments are met by public services

provided by the government. According to the benefit principle of taxation, taxes are prices

for certain public goods. However, the benefit principle does not necessarily imply that in-

come redistribution becomes impossible and only infrastructural goods as well as public con-

sumption goods are provided by the state. Citizens may perceive their tax payments as contri-
 – 14 –

butions to the ‘bonum commune’ such that they are willing to honestly declare their income

even if they do not receive a full public good equivalent to their tax payments. Income redis-

tribution is the more accepted by affluent citizens the more the political process is perceived

to be fair and the more policy outcomes are legitimate.

5.1 Establishing Social Exchange between Citizens and the Government

Empirically, the more governments follow the benefit principle of taxation and provide public

services according to the preferences of taxpayers in exchange for a reasonable tax price, the

more taxpayers indeed comply with the tax laws. Spicer & Lundstedt (1976), Porcano (1988),

Alm, McClelland & Schulze (1992) and Alm, Jackson & McKee (1992, 1992a, 1993) present

experimental evidence that governments which stick to the principle of fiscal exchange

achieve more tax compliance. Pommerehne, Hart & Frey (1994) use a simulation study design

to analyze the impact of fiscal exchange on tax compliance. They show that the more the citi-

zens’ optimal choice of a public good and the actual provision level and quality deviate from

each other, the higher is tax evasion. Tax compliance also increases with reductions in gov-

ernment waste. In the experimental papers, the proposed fiscal exchange relationship is based

on the provision of a public good financed by taxes. Several authors have used this analogy to

public good games in order to analyze additional variables that influence tax evasion (see e.g.

Feld & Tyran 2002). According to the benefit principle of taxation such a restricted view of

government action could be rationalized.

However, in real world settings the state undertakes many activities that cannot be subsumed

under the heading of a public consumption good or public infrastructure. In particular, any

kind of pure redistribution is not covered by such a design. Whenever redistribution of income

is at stake, problems of tax evasion are however pertinent. There are only a few studies that

consider the relationship between tax evasion and redistribution in a fiscal exchange setting.

In their experiments, Güth & Mackscheidt (1985) chose a simple tax-transfer-scheme to come
 – 15 –

as close as possible to the principle of vertical equity, i.e. take from the rich and give it to the

poor. They found that subjects had a compliance rate of 93 percent. Becker, Büchner & Sleek-

ing (1987) report however that evasion rises if taxpayers believe to lose from redistribution.

Obviously, the satisfaction with what the government provides in exchange for tax payments

strongly depends on the experimental setting or, in the real world, on the environmental con-

ditions. It appears that notions of fairness or justice shape the extent to which the fiscal ex-

change paradigm increases tax compliance in particular. Kinsey & Grasmick (1993) report

evidence that horizontal equity plays a role. If an individual’s tax burden is of about the same

magnitude as that of comparable others, tax compliance increases (see also Spicer & Becker

1980; De Juan, Lasheras & Mayo 1994). Kinsey & Grasmick (1993) and Roberts & Hite

(1994) report that vertical unfairness of the tax schedule (the progressivity of the income tax)

increases tax evasion. This is in line with the results by Scott & Grasmick (1981) who report

evidence that deterrence was more effective for taxpayers who perceived the tax system to be

unfair. Moreover, Scholz & Lubell (1998) emphasize the importance of trust in government

for tax compliance. In contract to their definition (1998: 411), trust in government is more

than a “rough measure of the net benefits from governing institutions”. It also involves the

effectiveness of the government to conduct the policies and programs promised to citizens. In

particular, trust in government can be eroded if government waste is high. Braithwaite (1998,

2003) underlines the delicate nature of a loss of trust when taxpayers are not confident that the

tax authority is able to regain its trustworthiness. Ahmed & Braithwaite (2004) report empiri-

cal evidence on a significantly higher non-compliance among those that have lost hope, i.e.

who believe that trustworthiness of the government is low.

5.2 Establishing Fiscal Exchange by Political Decision-Making Procedures

The fiscal exchange relationship between taxpayers and the state therefore depends on the

politico-economic framework within which the government acts. According to Alm, McClel-
 – 16 –

land & Schulze (1999: 149), rational egoists should vote for the lowest control intensities and

fines that are necessary to ensure compliance. However, the possibility for voters to vote di-

rectly on matters of content increases the legitimacy of policies and serves as an insurance

against exaggerated government waste. Direct political participation particularly activates

public spiritedness of taxpayers (Feld and Kirchgässner 2000).

In an experimental study, Feld & Tyran (2002) find that tax compliance is higher on average

in an endogenous fine treatment in which subjects are allowed to approve or reject the pro-

posal of a fine as compared to an exogenous fine treatment where the fine is imposed by the

experimenter (Alm, McClelland & Schulze 1999). The main explanation why people show a

higher tax morale if they are allowed to vote on a fine is legitimacy. Not only do subjects who

approve the fine in the endogenous fine treatment have a considerably higher tax compliance

than subjects in the exogenous fine treatment. Compliance rates are higher if the fine is ac-

cepted than in the case the fine is rejected. Subjects who reject the proposal of the fine show a

higher compliance rate than subjects in the exogenous fine treatment even if they know that

the dominant strategy under the existence of the low fine is non-compliance. Finally, indi-

viduals who vote against the fine contribute effectively more if the fine is adopted than indi-

viduals voting for the fine contribute in the case the symbolic fine is rejected.

Field studies by Pommerehne & Weck-Hannemann (1996), Pommerehne & Frey (1992) and

Frey (1997a) provide additional support for the experimental findings. Focusing on tax eva-

sion in the Swiss cantons between 1965 and 1978, they find that the more direct democratic

the political decision-making procedures of a canton are, the lower is tax evasion according to

those studies. These results are replicated by Feld & Frey (2002) and Frey & Feld (2002) by

extending the sample to period 1985 to 1995. Torgler (2005) uses an alternative approach to

study tax morale in the Swiss cantons by investigating two micro data sets, the World Value

Survey and the International Survey Programme, that contain questions about tax morale of
 – 17 –

respondents. His results provide evidence that direct democracy shapes tax morale. According

to his estimates, tax morale is significantly higher in direct democratic cantons. Distinguish-

ing between different instruments of direct democracy, he finds that the fiscal referendum has

the highest positive influence on tax morale. Moreover, tax morale of respondents is higher if

they have a higher trust in government, or in the courts and the legal system. Since studies for

the U.S. (Gerber 1999) and Switzerland (Pommerehne 1978) show that policies in direct

democratic jurisdiction are more strongly in line with citizens’ preferences, institutions of

direct democracy can be seen as a means to establish a relationship of fiscal exchange be-

tween taxpayers and the government.

In addition, Torgler (2005) reports evidence that local autonomy as an indicator of fiscal fed-

eralism has a marginally significant positive impact on tax morale. Güth, Levati & Sausgruber

(2005) find a stronger effect of fiscal decentralization on tax compliance in an experimental

setting. Subjects show a higher tax morale if public goods are provided and financed region-

ally or locally because their taxes are spent on their own regional or local public goods. The

fiscal equivalence of the theory of fiscal federalism then holds more strongly.

6 The Treatment of Taxpayers

The psychological tax contract is also supported by interactional justice, in particular a re-

spectful treatment of taxpayers by tax authorities. In order to investigate the relationship be-

tween taxpayers and tax authorities, Feld and Frey (2002) have sent a survey to the tax

authorities of the 26 Swiss cantons which asked detailed questions about the legal background

of tax evasion, but also included questions on the treatment of taxpayers by tax authorities in

day-to-day audits, in particular when a taxpayer is suspected of not declaring his or her true

taxable income. According to this survey, the extent of respectful treatment of the taxpayers is

captured by (1) Fully observing procedures based on formal and informal rules, i.e. what hap-

pens typically if a taxpayer does not declare taxable income at all (procedures, fines), if a tax
 – 18 –

declaration is mistakenly filled out or, in a second stage, if taxpayers do not react?; (2) Ac-

knowledgment of individual citizens’ rights and personality, i.e. what does the tax administra-

tion do if taxpayers declared taxable income by mistake too high? Are there attempts to find

out whether taxpayers intentionally or mistakenly declare too low a taxable income? Are mis-

takes in the tax declaration to the advantage or to the disadvantage of taxpayers?

The way taxpayers are treated by tax authorities reveals interesting differences between the

Swiss cantons. Only 58 percent of Swiss cantonal tax authorities believe that mistakes in re-

ported incomes are, on average, in favor of taxpayers. 31 percent believe that mistakes are

neither to the advantage nor to the disadvantage of taxpayers, and 12 percent believe that mis-

takes are to the disadvantage of taxpayers. These answers indicate that distrust towards tax-

payers is not universal. If a taxpayer does not report his or her true taxable income, tax

authorities contact her in several ways. 54 percent of the cantons phone the person concerned

and ask how the mistake(s) occurred in the tax declaration and how it can be explained. All of

the cantons send a letter to the taxpayer, half of them with a standard formulation. Nearly 85

percent ask the taxpayer to visit the tax office, but only half of the cantons mention the possi-

bility of punishment. Thus, while one half of the tax authorities rarely adopt the strategy of

explicit deterrence, the other rather seeks to gain additional information. 96 percent of the

cantonal tax authorities correct reported incomes that are too high, i.e. reduce taxable incomes

when taxpayers commit mistakes that are to their disadvantage. 27 percent of the tax authori-

ties correct reported taxable income even if taxpayers fail to profit from legal tax savings.

The impact of the treatment of taxpayers on tax evasion is studied more thoroughly in a re-

gression analysis by Frey and Feld (2002) and Feld and Frey (2002). With a sample of 26

Swiss cantons in the years 1970-1995, they show that the tax authorities in Switzerland do

indeed behave as if they were aware of the reaction of taxpayers to being treated with respect

or not. According to the empirical findings, tax evasion is lower, the more fully the tax office
 – 19 –

observes formal and informal procedural rules. The observation of procedural rules is indi-

cated by a distinction between friendly treatments, for example a respectful procedure, and

unfriendly treatments, like an authoritarian procedure or the tax authorities’ direct deterrence

to fine. It can be shown that the friendly treatment has a stronger dampening effect on tax

evasion particularly in cantons using referendums and initiatives in political decision-making,

while the authoritarian procedure, the threat of deterrence, is particularly reducing tax evasion

in representative democracies, but counter-productive in direct democracy. Moreover, Swiss

citizens are the more respectfully treated by the tax authority the more strongly developed

citizens’ participation rights (Feld and Frey 2002a). In addition, tax authorities in more direct

democratic cantons appear to give taxpayers more frequently the benefit of a doubt. Feld and

Frey (2002a) report evidence that tax authorities in more direct democratic cantons believe to

a significantly lesser extent that mistakes in the tax declaration are in favor of taxpayers.

7 Conclusions

A fundamental result of the tax evasion literature is that it is still not fully resolved why peo-

ple actually pay taxes, given the rather low levels of fines and auditing probabilities. The de-

terrence model of tax evasion cannot explain the high tax compliance rates without referring

to an exogenously given tax morale. In this paper, we have argued that tax compliance results

from a complicated interaction of deterrence measures and responsive regulation. Citizens and

the state develop their fiscal relationships according to a psychological tax contract that estab-

lishes fiscal exchange between taxpayers and tax authorities. It reaches however beyond pure

exchanges and involves loyalties and ties between the contract partners. Tax morale is there-

fore a function of (1) the fiscal exchange where taxpayers get public services for the tax prices

they pay, (2) the political procedures that lead to this exchange and (3) the personal relation-

ship between the taxpayers and the tax administrators.

In particular the empirical evidence on Switzerland summarized in this paper underlines these

arguments by showing a family of tax jurisdictions where something like a psychological tax

contract appears to be in place. There, the tax authorities take into account that the way they

treat the taxpayers systematically affects the latter’s tax morale, and therefore their willing-

ness to pay taxes, which in turn affects the costs of raising taxes. In addition, tax compliance

in Switzerland is shaped by direct democracy establishing a fiscal exchange relationship be-

tween taxpayers and the state. Although the empirical evidence provided relates to Switzer-

land (and the U.S.), we are confident that the issues here considered are valid more generally.

The contractual view adopted in this paper allows for a coherent consideration of the impact

of emotions and personal attitudes on tax compliance behavior as it is emphasized in the psy-

chological literature. It also goes beyond the arguments for responsive regulation provided by

Ayres & Braithwaite (1992) by suggesting that genuinely rewarding taxpayers in an exchange

relationship will increase tax compliance. It should thus be considered as the dominant strat-

egy to approach taxpayers in order to enhance their tax compliance, while it is still able to

resort to punishment if that strategy fails. The theoretical argument of a psychological tax

contract thus has the ability to bridge economics, law and policy.

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