Royal Economic Society

TAX CHEATING: HOW DIRECT DEMOCRACY RATHER THAN TOUGHER PUNISHMENT DISCOURAGES DISHONESTY
Trust pays, according to Professor Bruno Frey writing in the latest issue of the Economic Journal. Letting citizens participate more fully in politics (for example, through popular referenda) is not only a step towards more democracy but also reduces tax cheating. And empirical evidence supports this view: Frey finds that tax cheating in Swiss cantons with direct democracy is 8% lower (£1,000 per person per year) than in cantons operating with more traditional representative democracy.

Frey notes that tax cheating is a pervasive problem throughout the world. The way to combat it, he suggests, is by putting more trust in citizens, rather than trying to control and punish offenders more severely. The normal reaction to illegal behaviour has always been to make the offence less attractive by monitoring more extensively and by imposing higher sanctions.

But this policy is likely to backfire. It indicates that the state mistrusts its citizens. The citizens respond by exhibiting a lower degree of civic virtue, which in turn changes their attitude towards the state. They then make an effort to exploit the system as much as possible, in particular, seeking ways of cheating on their taxes.

Frey’s research suggests that in the long run, the state does much better by putting more rather than less trust in its citizens. Most importantly, the citizens can be given more direct participation rights in the political process in the form of popular referenda and initiatives.

The citizens then respond by exhibiting higher civic virtue. They are more prepared voluntarily to pay the taxes needed to provide public services. Of course, they only behave in this benevolent way if they are convinced that other citizens are prevented from exploiting this more lenient system.

Such a policy might seem like wishful thinking. Yet Frey’s study demonstrates that this is not the case. A comparison of Swiss cantons that have well-developed direct democratic institutions with cantons relying more on representative democracy provides empirical evidence.

In the more direct democratic cantons, tax cheating is about 8% lower than elsewhere in Switzerland. This means that 2,000 Swiss francs (roughly £1000) less are evaded per person per year, a substantial sum. In contrast, tax cheating is substantially higher in the cantons with more representative democratic systems. This difference in tax-paying behaviour can be attributed to the different forms of democracy as other influences have been netted out.

Frey’s results have relevance beyond taxation; they concern more generally the relationship between the state and its citizens: direct democracy can be considered a model of democracy for the coming millenium. Of course, a constitution must prevent ‘knaves’ from exploiting the system to the disadvantage of the honest citizens. But it should not be based on tight controls and heavy punishments.

While this is a knee-jerk reaction to tax cheating and other illegal acts, a longer run view should endeavour to involve the citizens more in the affairs of the state by giving them more political participation rights. This study provides an empirical basis for such a programme, demonstrating that it is not solely based on idealism but that it is practically feasible.

Note: ‘A Constitution for Knaves Crowds Out Civic Virtues’ by Bruno S. Frey is published in the July 1997 issue of the Economic Journal. Frey is Professor of Economics at the University of Zurich.

For Further Information: contact Bruno Frey on 00-41-1-257-37-30/31; (home: 00-41-1-261-4767 or 00-41-71-622-4362; fax: 00-41-1-364-0366; email: bsfrey@iew.unizh.ch); or Melanie Dean of the RES/ESRC Economists in the Media Initiative on 0171-878-2913 (email: mdean@cepr.org).