Sample Research Proposal: VAT Compliance in the UK

Table of contents

1.1 Introduction

Income tax, National Insurance contributions, and Value Added Tax (VAT) contribute approximately two-thirds to total tax revenue in the Uk (Adam and Browne, 2009). VAT, which is a proportional tax paid on all sales, has become an important source of revenue in Britain, particularly as the government is under great pressures to raise revenue to ‘balance the budget’ (Adams and Webley, 2001). A business has to register for VAT when their taxable supplies in the last twelve month period surpass or are expected to surpass the current registration limit of ?70,000. The VAT is a flat rate scheme with a current rate of 17.5%, up from 15% (a rate which applicable from 01 December 2008 to 31 December 2009 as part of an economic stimulus package) (Adam and Browne, 2009). In addition to this flat tax that applies to the vast majority of goods and services purchased, there are a few items that are zero-rated, such as most foodstuff, exempt, such as health services and private education, and some with a lower rate of VAT (5%), such as baby car seats and domestic fuel and power (Adam and Browne, 2009). While items falling into these classes are not affected, the standard rate of VAT is set to increase to 20% from 4 January 2011.

Investigators have found that small businesses people believe that the present rate of 17.5% is too high and promotes negative feelings towards VAT and full compliance (Adams and Webley, 2001). Given the increase in January 2010, what will be the impact on compliance ratesThis is an important issue, since research shows that VAT is more efficiently collected when VAT rates are low (de Mello, 2009). While the level of tax evasion in the UK has been found to be much smaller than in some other countries (Agha and Haughton (1996) reported evasion of 3% in the UK compared to 40% in Italy), even small amounts of evasion represent large losses in revenue. Still, there has been little research on VAT compliance over the last three decades, with research focusing mainly on income tax compliance (de Mello, 2009; Webly, 2004). I think that this is a very interesting and important topic of research because of the impending increase in the rate of VAT in the UK and the current paucity of research in this area. The lack of research on VAT in particular makes it difficult to assess the impact of the increase and so I think this is an area worth investigating more.

1.2 Research Aims and Objectives

The purpose of this study is to build on previous research into tax evasion in general, and VAT evasion in particular, to present a description of small businesses’ perspectives on VAT and related issues. The specific objectives of this research are:

To describe small businesses’ perspectives on paying VAT and related issues,
To investigate the degree to which social and psychological factors play an important role in evasion of VAT, and
To investigate the possible impact of the increase in VAT on in evasion.

This paper has two additional sections. The second section is the preliminary Literature Review, in which the research on VAT compliance and important social psychological factors is discussed. Section three details the Methodology, outlining how the research will be carried out.

2.1 Introduction

People’s willingness to pay taxes depends on a range of variables. Economists tend to highlight the importance of the relevance of exogenous variables such as tax rate, income, and probability of detection and the level of sanctions, while psychological research demonstrates that endogenous variables are also significant, including taxpayers’ attitudes toward the government and taxation, personal norms, perceived efficiency and equity (Hofmann et al., 2008; Kirchler, 2007). In taking these together, Cullis and Lewis (1997: 320) terms this the ‘economic psychology approach,’ which combines the “positive approach the empirical world” with “the softer approach” in which people “comply with taxes for different reasons and … the tax compliance problem is in part socially constructed.”

Adams and Webley’s (2001) have undertaken research specifically investigating VAT compliance and uncovered fifteen main concepts falling into five key themes that they thought to be relevant. Of the five major themes, four were recurrent in previous research on income tax compliance research: equity, attitudes toward taxation and tax authorities, sanctions, and personality/morality. The fifth theme they highlighted was ‘mental accounting,’ which they note is a recognised psychological construct but has not previously been applied in the area of tax compliance. This five-factor model was echoed in Webley et al. (2006), who extended the research undertaken by Adams and Webley (2001) and found that mental accounting and equity were particularly important factors affecting VAT compliance. These five factors are briefly discussed here.

2.2 Sanctions and Punishments

In economics, the basic theory of tax evasion is an application of the theory of choice under uncertainty (Clotfelter, 1983). In the standard approach to tax evasion, a risk-averse individual chooses either the amount or the share of income to be concealed so as to maximise her expected utility of income, considering (1) the probability of detection, (2) the penalty tax rate applied when tax evasion is detected, (3) the marginal tax rate, and (4) the level of true income (Pommerehne and Weck-Hannemann, 1996). Thus, the problem a person has to tackle is whether or not to evade some part of her legal tax liability given that there is a probability of being caught if she decides to be non-compliant. Therefore, economic models focus on the role of penalties and audits, with economists theorising that greater penalties and audit probabilities should increase compliance (Slemrod, 2007). Empirical research indicates that both penalties and audits can lead to greater compliance (Andreoni et al., 1998), although higher penalties have been shown to be less of a deterrent than higher audit probabilities (Hessing et al., 1992).

2.3 Equity

At the centre of tax policy are concepts of equity (fairness) as the perceived fairness of a tax system has been found to be is essential to its acceptability and smooth functioning (Adams and Webley, 2001; Hofmann et al., 2008). This ‘first, basic rule of taxation’ is based on Adam Smith’s first maxim of a good tax, which reads:

The subjects of every State ought to contribute towards the support of the government as nearly as possible in proportion to their respective abilities – that is, in proportion to the revenue which they respectively enjoy under the protection of the State (as cited in Musgrave, 2002: 10).

Wenzel (2003) discusses three types of fairness that are applicable in this area. Distributive justice deals with the fair exchange of resources, benefits, and costs, procedural justice deals with the issue of tax collection and resource distribution, while retributive justice deals with the perceived fairness of audit and punishment as discussed above. Overall, research demonstrates that, where taxpayers feel there is a disparity in the exchange relationship, it is more likely that people will be non-complaint in order to offset or reduce the perceived inequity (Cowell, 1992). In recent work by Webley and colleagues on VAT and small businesses (Adams and Webley, 2001; Webley et al., 2004) the idea that small businesses especially are unfairly treated in the current system was a frequent theme.

2.4 Personality/Morality

In their research, Adams and Webley (2001) discuss the impact of egoism on compliance behaviour. They draw on research by Weigel et al. (1998) indicating that people that have egoistic tendencies are more likely to break rules when these rules are not in their personal self-interest and thus are more likely to try to avoid paying taxes. This idea is supported by research showing that egoism is a good indicator of the individual’s propensity to evade income taxes (Elffers, 1991), engage in benefits fraud (Hessing et al., 1993), and incur parking violations (Adams and Webley, 1996). Researchers have also outlined other important norms that may be important in influencing tax compliance, such as authoritarianism and Machiavellianism (Kirchler et al., 2008), and the overall conclusion from the research in this area is that people with more developed moral reasoning or tax ethics are more likely to be compliant (Hofmann et al., 2008; Trivedi et al., 2003).

2.5 Satisfaction with the Tax Authorities

Theoretical and empirical research indicates that dissatisfaction with the tax authorities is one of the reasons for non-compliance (Adams and Webley, 2001; Elffers, 1991; Hofmann et al., 2008; Webley et al., 2006). One way to look at this is based on efficiency, with research showing that people that think the tax system is inefficient are less likely to comply (Wearing and Heady, 1995).

2.6 Mental Accounting

Finally, Adams and Webley (2001) and Webley et al. (2006) have found that the way in which business people see the VAT money they collect is an important factor in whetner they choose to comply with VAT laws or not and use the idea of ‘mental accounting’ (see to develop this point. According to Webley et al. (2006: 178):

Mental accounting is often described as a psychological mechanism whereby income is framed…. in respect of personal finance …people have a number of mental accounts that operate independently of one another. What is interesting in the current context is whether business men and women psychologically separate monies owed to the VAT into a separate mental account from that of business turnover. If they do not, they may be more likely to try to evade VAT as a result of seeing it as ‘their’ money.

The results of their research is that most of the business people saw the money collected as theirs and therefore disliked handing it over to HM Revenue and Customs.

2.7 Summary

As noted in the Introduction, there has been little research on VAT compliance over the last three decades and this is reflected in the literature that has been reviewed here. However, brief review of the literature on VAT compliance, combined with the insights from the research on income tax compliance, indicates that businesses’ willingness to comply with VAT laws is influenced by sanctions, but also by a number of internal factors, important among which are perceptions of equity and their mental accounting. These five factors discussed will be used as starting points to investigate the issue as the literature search is extended over the next few months.

3.0Methodology

Based on the research objectives outlined in the first section, secondary research was thought to be appropriate. Secondary research is the summary, collation, and/or synthesis of existing research (Robson, 2002). While secondary analysis is an important feature of the research and evaluation landscape, “few researchers consider the possibility of re-analysing data that have already been collected for some other purpose” (Saunders et al., 1997: 158). I initially considered undertaking a typical research strategy which would include the collection of data directly from one or more business owners and then its subsequent analysis using statistics. However, this did not seem the best manner in which to collect the evidence that was necessary primarily because time and monetary constraints meant that I would not be able to undertake research in several different types of businesses or on large samples of businesspeople.

In constructing in method, a secondary information search strategy was put together with two main steps. The first step is to specify the data needs, which was empirical and theoretical articles dealing with VAT compliance. The second step includes specifying the data retrieval method. Both manual and electronic retrieval methods will be used. In the electronic search, two approaches will be used to locate relevant articles. First, a keyword search will be conducted, meaning that keywords relating to VAT evasion will be identified and then used in various search engines to locate relevant material. The next approach will be based on the previous searches, meaning that relevant material cited in the data sources already collected will be located and collected. Data will be presented using traditional narrative reviews, which use a narrative format to summarise the findings of primary studies on a coherent topic to attempt to draw conclusions or inform theory (Robson, 2002).

There are two main limitations of this method. First, the research subject deals with matters that relate to contemporary issues and ay be restricted by deep-seated social, historic and regional biases. Second, the insufficiency of published information on VAT compliance in comparison to other more well-researched aspects of tax compliance are underlying limiting factors that restrict availability of requisite secondary information. This may result in the omission of significant information that may well have improved the research conclusions.

References

Adam, S. and Browne, J. (2009). A survey of theUKtax system. Institute of Fiscal Studies Briefing Note No. 9 [online]. Available at http://www.ifs.org.uk/bns/bn09.pdf [cited 17 March 2010].

Adams, C. and Webley, P. (1996). The role of economic and psychological variables in parking violations. Psychology, Crime and Law, 3: 111-133.

Adams, C. and Webley, P. (2001). Small business owners’ attitudes on VAT compliance in the UK. Journal of Economic Psychology, 22 (2): 195-216.

Agha, A. and Haughton, J. (1996). Designing VAT systems: Some efficiency considerations. The Review of Economics and Statistics, 78 (2): 303-308.

Andreoni, J., Erard, B., and Feinstein, J. (1998). Tax compliance. Journal of Economic Literature, 36 (2): 818-860.

Clotfelter, C. (1983). Tax evasion and tax rates: An analysis of individual returns. The Review of Economics and Statistics, 65 (3): 363-373.

Cowell, F. (1992). Tax evasion and inequity. Journal of Economic Psychology, 13, 521- 543.

Cullis, J. and Lewis, A. (1997). Why people pay taxes: From a conventional economic model to a model of social convention. Journal of Economic Psychology, 18 (2/3) 305-321.

Davies, M. (2007). Doing a Successful Research Project. Basingstoke: Palgrave Macmillan.

de Mello, L. (2009). Avoiding the Value Added Tax: Theory and cross-country evidence. Public Finance Review, 37 (1): 27-46.

Elffers, H. (1991). Income Tax Evasion: Theory and Measurement. Amsterdam: Kluwer.

Hessing, D. J., Elffers, H., Robben, H. S. J., and Webley, P. (1993). Needy or greedyThe social psychology of individuals who fraudulently claim unemployment benefits. Journal of Applied Social Psychology, 23: 226-243.

Hessing, D., Elffers, H., Robben, H., and Webley, P. (1992). Does deterrence deterMeasuring the effect of deterrence on tax compliance in field studies and experimental studies. In Slemrod, J. (ed.), Why People Pay Taxes: Tax Compliance and Enforcement (p. 291-305). Michigan: University of Michigan Press.

HM Revenue and Customs (2010). VAT – change of the standard rate to 20 per cent: A detailed guide for vat-registered businesses. 22 June. Available online at http://www.hmrc.gov.uk/vat/forms-rates/rates/rate-rise-guidance.pdf [accessed 28 November 2010].

Hofmann, E., Hoelzl, E., and Kirchler, E. (2008). Preconditions of voluntary tax compliance: Knowledge and evaluation of taxation, norms, fairness, and motivation to cooperate. Journal of Psychology, 216 (4): 209-217.

Kirchler, E. (2007). The Economic Psychology of Tax Behaviour. Cambridge, UK: Cambridge University Press.

Kirchler, E., Hoelzl, E., and Wahl, I. (2008). Enforced versus voluntary tax compliance: The ‘slippery slope’ framework. Journal of Economic Psychology, 29 (2): 210-225.

Musgrave, R. (2002). Equity and the case for progressive taxation. In Thorndike, J. and Ventry, D. (eds.), Tax Justice: The Ongoing Debate (p. 9-24). Washington, DC: Urban Institute Press.

Pommerehne, W. and Weck-Hannemann, H. (1996). Tax rates, tax administration, and income tax evasion in Switzerland. Public Choice, 88, (1/2): 161-70.

Robson, C. (2002). Real World Research: A Resource for Social Scientists and Practitioner-Researchers. Oxford: Blackwell.

Saunders, M., Lewis, P., and Thornhill, A. (1997). Research Methods for Business Students. London: Pitman Publishing.

Slemrod, J. (2007). Cheating ourselves: The economics of tax evasion. Journal of Economic Perspectives, 21 (1): 25-48.

Trivedi, V., Shehata, M., and Lynn, B. (2003). Impact of personal and situational factors on taxpayer compliance: An experimental analysis. Journal of Business Ethics, 47 (3): 175-197.

Wearing, A. and Heady, B. (1995). The would-be tax evader: A profile. Paper presented at the Australian Tax Office Compliance Research Conference, Canberra, 1995.

Webley, P. (2004). Tax compliance by businesses. In Sjogren, H. and Skogh, G. (eds.), New Perspectives on Economic Crime (p. 95-126). Cheltenham: Edward Elgar.

Webley, P., Adams, C., and Elffers, H. (2006). Value Added Tax compliance. In McCaffery, E. and Slemrod, J. (eds.), Behavioural Public Finance (p. 175-205). New York, NY: Russell Age Foundation.

Weigel, R., Hessing, D., and Elffers, H. (1998). Egoism: Concept, measurement, and implications for deviance. Psychology, Crime and Law, 5: 449-478.

Wenzel, M. (2003). Tax compliance and the psychology of justice: Mapping the field. In Braithwaite, V. (ed.), Taxing Democracy: Understanding Tax Avoidance and Evasion (p. 41–69).

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