Experimental Evidence on Taxpayer Reporting under Uncertainty

Tax law complexity and ambiguity may result in uncertainty about taxable income (Slemrod 1988) and are of concern to policy-making bodies such as the ABA, the AICPA, and the IRS (Sheppard and Evans 1990). Several studies have modeled the effects of uncertainty on taxpayer reporting and the role of tax practitioners in reducing uncertainty (Alm 1988; Shavell 1988; Beck and Jung 1989a, 1989b; Scotchmer 1989a, 1989b; and Scotchmer and Slemrod 1989). Empirical and experimental research, however, have not kept pace. This paper reports experimental tests of the effects of income uncertainty and other economic factors based on tax reporting models in Beck and Jung (1989a). Hypotheses were tested regarding the effects of changes in the uncertainty level, tax rate, penalty rate, and audit probability on reported taxable income. In addition, the explanatory power of the models was evaluated by comparing the taxable income reported by the subjects with model-based predictions. Subjects were endowed with a fictitious currency and were given a range of possible post-audit taxable incomes from which to report. A proportional tax was paid on reported income and, in the event of an audit, a monetary penalty was imposed when the actual taxable income was greater than the amount reported. Incentives were provided by making the subjects' post-experimental remuneration a function of the after-tax income retained from each experimental trial. Since previous theoretical research indicates that taxpayers' reporting decisions are sensitive to risk preferences, three seperate experiments were performed and the results were analyzed by repeated measures ANOVAs. In the first and second experiments, subjects' risk-taking attitudes were controlled by the Berg et al. (1986) mechanism. Risk-neutrality (risk-aversion) was induced in the first (second) experiment, while subjects' preferences in the third experiment were measured ex post, rather than controlled. Two measures of taxpayer reports were employed-the actual income reported by subjects and the corresponding reporting fractile. The experimental results provided support for risk-neutral predictions. First, risk-neutral subjects were found to report higher levels of income when penalty rates and audit probabilities increased. Second, the tax rate did not affect the reporting behavior of risk-neutral subjects. Third, income reports were affected by two interactions: audit probability with uncertainty and penalty rate with uncertainty. Specifically, a reduction in uncertainty led to higher (lower) levels of reported taxable income when penalty rates or audit probabilities were decreased (increased). In addition, the mean reporting fractile did not change with the uncertainty level and the deviation of mean observed reports from predicted levels was small. For the risk-averse model, the predicted tax rate effect was marginally significant for reports and insignificant for fractiles. Furthermore, only a small percentage of the variance was explained by the interaction of tax rate and uncertainty. Report fractiles, however, did increase significantly as predicted when uncertainty was elevated.