Tax Compliance Meaning

What does tax compliance mean? Tax compliance is the individual or business decision to comply with the tax laws in a given country. There are many tax laws that exist at the state and federal levels. In addition, tax laws can differ from state to state. For example, some states may not have property taxes, while others may have higher sales taxes. Regardless of the tax laws that are put in place, tax compliance relies on people to abide by the tax laws. Now that we have an understanding of tax compliance let's look at its counterpart: tax evasion.

Diametrically opposed to tax compliance is tax evasion. Tax evasion is the individual or business decision to avoid or underpay the taxes imposed on them — this practice is illegal. Do not get tax evasion confused with tax avoidance. In contrast, tax avoidance is the ability to lessen tax liability to maximize post-tax income — this practice is legal. Failing to report your true income is illegal (tax evasion), whereas claiming a credit for child-care expenses is legal (tax avoidance).

In the example above, Josh tried to hide the income that he earned in order to prevent paying taxes. While it might sound great not having to pay taxes, this practice is illegal and prohibited in the United States.¹ In addition, taxes are such an integral part of a functioning economy; so functional that you may not even realize its benefits all around you!

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Tax Compliance Example

Let's go over an example of tax compliance. We will look at an example of both the individual and business decision to comply with taxes.

Individual Tax Compliance

Individual tax compliance revolves around reporting accurate yearly income. In the United States, individuals file their taxes and are required to file them appropriately, given how much income they earn. If individuals fail to report all of their income to avoid paying taxes, then this would be tax evasion.² While individuals are responsible for filing their taxes accurately, they can also pay for a service to assist them in this process; after all, the penalty for not complying is quite large!

Business Tax Compliance

Importance of Tax Compliance

What is the importance of tax compliance? The importance of tax compliance is that by paying their taxes, individuals and businesses are funding the government's tax revenue. Government tax revenue is important for a variety of reasons, from balancing the budget to providing goods and services to its citizens. Without a consistent stream of tax revenue, the government would not be able to accomplish these goals. Let's take a deeper look at how tax revenue is used to balance the budget and pay for goods and services.

Balanced Budget

For a government to properly balance its budget, it will need to account for its revenue and spending. Let's look at the equation for the budget balance for further clarification:

Savings=Tax Revenue−Government Spending

What does the equation above tell us? In order for the government to balance its budget, it needs to offset any high government spending with increased tax revenues. One way the government can do this is to simply increase the tax rate for all citizens and businesses. By enforcing tax compliance, the government can increase the tax rate and increase its tax revenue to balance its budget. However, what if individuals and businesses choose not to pay taxes?

If this occurred, the government would not be able to balance its budget. Prolonged deficits can be problematic and even result in a country defaulting on its debt. It is for this reason that tax compliance is important when it comes to balancing the budget.

Let's now take a look at the importance of tax compliance regarding goods and services.

Goods and Services

The government provides us with a multitude of goods and services. How exactly does it do that? Through what mechanisms can the government provide us with so many goods and services? The answer: tax revenue! But what is the relationship between tax revenue and goods and services?

In order for the government to provide goods and services, they need to make purchases and transfers. Government purchases include increased spending on defense and infrastructure, whereas government transfers include services like Medicare and Social Security. Of course, we know that the government can't just make money out of thin air! Therefore, the government needs its source of revenue to provide goods and services to its citizens.

In order for the government to obtain tax revenue, its citizens need to comply with the tax laws. If they do not, then tax revenue will be limited in the country. Without tax revenue, the government would have a difficult time providing important goods and services. Medicare and Social Security may cease to exist, city infrastructure may be dilapidated or unsafe, and a host of other issues. Tax revenue is an important part of the process, and in turn, tax compliance becomes just as important as well.

Tax Compliance Theories

Let's discuss tax compliance theories. First, let's explain what a theory is. A theory is a set of guiding principles that are used to explain a phenomenon. In regard to tax compliance, utility theory, developed by Allingham and Sandmo, aims to see how taxpayers behave when it comes to tax compliance and tax evasion. Generally, taxpayers want to maximize their utility when it comes to reporting their taxes.⁴ If the gains of tax evasion outweigh the costs, then taxpayers are more likely to evade their taxes and not comply with the tax laws.

Another aspect of theories is the components that make up the theory in the first place. For example, James Alm believes that there are key elements that are included in most tax compliance theories. Those elements include detection and punishment, overweighting of low probability, the burden of taxation, government services, and social norms.⁵ Let's take a deeper look at the social norm element.

Social norms can have a major impact on whether people comply with tax laws. If people typically see tax evaders as immoral, then most people are likely to comply with the tax laws. Additionally, if someone were to have friends who are tax evaders, then they are likely to evade their taxes as well. If people perceive that the tax law is unfair, compliance is likely to decrease as a result. It's important to mention that this is just one element of the five listed above! A lot goes into developing a theory of tax compliance, and there are many moving parts to explain this human behavior.