Art and psychology of managing a good tax system

Designing an effective tax policy is akin to creating a piece of art, where every decision and strategy must be carefully crafted to achieve the desired outcomes

Taxation is often seen as a straightforward economic function, primarily aimed at generating revenue for public services. However, the process of designing and managing a tax system is much more nuanced. It involves both art and psychology, requiring a comprehensive understanding of economic principles, social behaviour, and cultural contexts. This is especially relevant for countries like ours, where tax policies have frequently fallen short due to a lack of consideration for these critical aspects.

The art of tax policy

Designing an effective tax policy is akin to creating a piece of art, where every decision and strategy must be carefully crafted to achieve the desired outcomes. The artistry in tax policy lies in balancing several key factors:

1. Equity and fairness: An equitable tax system ensures that the tax burden is fairly distributed across various income groups. In Sri Lanka, perceptions of inequity are a major concern, with certain groups shouldering a disproportionate share of the tax burden while others evade taxes altogether. The heavy reliance on regressive taxes, such as Value Added Tax (VAT), exacerbates this issue. Although there have been proposals to address this by reducing regressive taxes, there has yet to be a comprehensive strategy to effectively tackle the underlying inequities in the system.

2. Efficiency: A well-designed tax system should minimise economic distortions and avoid discouraging productive activities. In Sri Lanka, inefficiencies within the tax system have caused frustration and widespread non-compliance, significantly undermining the effectiveness of tax collection. These issues are further exacerbated by inconsistent enforcement of tax laws across different taxpayer groups.

3. Simplicity: Complex tax laws and regulations can lead to confusion and non-compliance. The art of tax policy involves simplifying the system as much as possible while still achieving policy goals. Sri Lanka’s tax policies have often been criticised for their complexity, which complicates compliance and enforcement. Although there have been efforts to reduce complexities recently, more focus is needed on small and medium enterprises (SMEs), as current compliance requirements are particularly burdensome for them.

4. Revenue sufficiency: The primary function of a tax system is to generate sufficient revenue to fund government services and infrastructure. Crafting policies that meet revenue needs without overburdening taxpayers is a delicate balancing act. In Sri Lanka, frequent changes to tax laws and regulations have led to uncertainty and a lack of trust among taxpayers. This inconsistency is often due to a lack of proper studies and methodical implementation of tax policies, resulting in a trial-and-error approach that has failed to yield stable outcomes.

5. Incentive structures: Effective tax policies should include incentives that encourage desirable behaviours, such as investment in green technology research and development or education. This requires an understanding of how different incentives will be perceived by various segments of the population. In Sri Lanka, incentives have not always been strategically aligned with long-term economic goals, often resulting in suboptimal outcomes. Certain incentives have been offered without thorough economic analysis, undermining their intended purpose.

The psychology of taxation

Beyond technical considerations, tax policy also involves understanding human behaviour. Psychological factors play a crucial role in how tax policies are perceived and followed:

1. Perceptions of fairness: People’s willingness to comply with tax policies is heavily influenced by their perceptions of fairness. If taxpayers feel the system is unjust, they are less likely to comply. In Sri Lanka, widespread perceptions of unfairness have led to significant evasion and resistance to tax laws. Fairness was a highly debated concern, especially after the economic turmoil and the increase in tax rates. 

2. Trust in Government: Trust is a fundamental psychological factor in taxation. When taxpayers believe that the government uses their money efficiently and transparently for the public good, they are more likely to comply with tax obligations. In Sri Lanka, a persistent lack of transparency and accountability in public spending has significantly eroded trust, fostering a culture of non-compliance. For years, there has been ongoing public debate and numerous accusations regarding the inefficient use of tax revenues and the misappropriation of public funds, which remain major concerns among citizens.

3. Behavioural economics: Insights from behavioural economics are crucial for designing effective tax policies. Understanding how people respond to various incentives and penalties can help policymakers craft tax systems that encourage better compliance. Unfortunately, Sri Lankan tax policies have not consistently applied these insights, missing opportunities to improve compliance through strategic nudges and incentives. A notable example is the recent gazette notification issued requiring all resident individuals to obtain a Taxpayer Identification Number (TIN), which included a penalty of Rs. 50,000 for non-compliance. Despite this penalty, many residents have not yet obtained a TIN, highlighting the importance of understanding taxpayer behaviour when designing and implementing tax policies.

4. Cultural norms and values: Cultural factors significantly influence how tax policies are perceived and accepted. Norms related to civic duty, social responsibility, and attitudes toward the government can differ greatly across societies. In Sri Lanka, a disconnect between tax policies and cultural values has often resulted in resistance and evasion. For example, it is a local tradition to gift assets to children upon marriage as a gesture of love and affection. However, under the current provisions of the Inland Revenue Act, such gifts are treated as sales, except for land and buildings. This approach can create psychological barriers and resistance to compliance. To ensure better acceptance, tax laws and regulations must be designed with careful consideration of cultural practices and values.

5. Psychological framing: The presentation of tax policies can greatly affect their acceptance and compliance. Positive framing, which emphasizes the benefits of tax-funded services, can enhance voluntary compliance. In contrast, negative framing, which focuses on penalties for non-compliance, may lead to resistance. In Sri Lanka, the communication of tax policies has not always effectively utilised these psychological insights. To improve compliance, it is essential that tax policies are presented positively, alongside fostering greater trust in the Government and addressing other key factors.

Conclusion

Designing and managing an effective tax system requires both artistic creativity and psychological understanding. Unfortunately, Sri Lankan policymakers have frequently overlooked these essential elements. The failure to balance key objectives—such as equity, efficiency, and simplicity—has resulted in a tax system that is perceived as complex, unfair, and inconsistent. Additionally, psychological factors influencing taxpayer behaviour, including perceptions of fairness, trust in government, and cultural norms, have not been adequately addressed.

By neglecting these fundamental principles, Sri Lanka’s tax policies have struggled to achieve their intended goals. Moving forward, it is vital for policymakers to appreciate the significance of these concepts and strive to create a tax system that not only meets fiscal needs but also promotes fairness and trust among citizens. This approach will improve compliance, ensure the sustainable delivery of public services, and contribute to a more robust and equitable economy, providing a more sustainable solution than focusing solely on economic and legal aspects of taxation.

(The writer is a Chartered Accountant.)