Business taxation: a transaction cost theory perspective

The tax evasion scenario is more probable for economies with low tax morale. However, tax morale itself is also an endogenous factor resulting from the economic, social and cultural development of a given society. Tax morale, and as a result tax evasion, is affected by mentality, societal values, attitudes to the government and other non-economic factors. Tax evasion can also be promoted by purely rational short-run considerations. Businesses that avoid paying taxes and work at least partially in the shadows, gain a competitive advantage in terms of costs (price) over those who pay taxes diligently. Thus, those who in principle are willing to pay taxes are forced to join the informal sector for the sake of survival. This effect may be self-enforcing, which makes it rather difficult for tax reformers to break this vicious circle.

Thus, in a society with a high tax morale and relatively small size of the informal sector, it is possible to reduce the enforcement efforts and loosen control over businesses thus reducing transaction costs on both the business and government side. In a society with low tax morale and a large shadow economy tax transactions costs may be rather high because the tax authorities must take additional measures to discourage businesses from tax evasion.

According to the DB (PT) methodological framework, the more conducive to business development tax systems are characterized by lower tax rates. The question arises whether the lowest tax rates can be considered as a benchmark for tax reformers, which must balance the interests of different groups of stakeholders affected by the tax system.

Summarizing major criticisms of the Doing Business project, Besley (2015) states: «Particular attention has focused on whether it is valid to collect the separate rankings into an aggregate ranking». This concern can be extended to the Paying Taxes part. Is it justified to combine total tax rate and, for example, time to comply with tax requirements to get the overall ranking? Are tax systems with lower total tax rates necessarily better than those with higher rates? After all if taxes are spent rationally by the government, business can also benefit from it, in particular if it concerns the provision of high-quality transaction goods that facilitate market transactions and thus help reduce overall transaction costs for business. Tax rates depend on the societal values, macroeconomic goals and other factors which can be different for different societies.

More efficient tax systems may serve as models, but mere copying of those systems by less developed countries is impossible, as any tax system is built taking into account macroeconomic indicators, institutional, cultural and other peculiarities of a country. There is no ideal tax system, at least according to the methodology used in the Paying Taxes project because ranks are calculated using a compensatory model - a lower performance on one sub-indicator may be outweighed by a higher performance on some other indicator. However, are such tradeoffs always justified? While a reduction in the transaction costs, specifically in the time spent on complying with tax regulations, provided that it does not affect negatively tax revenues, can be considered a positive change, a reduction in the total tax rate does not necessarily meet the societal goals. In more socially oriented economies taxes are usually higher but so are economic performances. Besides, shares of different taxes in the total tax rate can be distributed in different ways. In some economies a stronger emphasis is placed on labor taxes (France, Belgium, Italy), in others on profit taxes (the United States, Malta). From the point of view of business, lower taxes are preferable to higher ones, but when improving a tax system one should take into account interests of other important stakeholders too.

Thus, there are multiple solutions to the problem of building a tax system which must be the best fit for a particular society. At the same time cross-country differences should be acknowledged but not overstated when explaining the lack of progress in the improvement of tax systems. Other possible reasons are bureaucratic inertia, the shortage of professionals capable of developing and implementing sound tax policies, the lack of political will, the existence of stakeholders who benefit from the existing system.

Transaction cost theory provides a useful framework for understanding and interpreting socio-economic phenomena related to business taxation. Taxes themselves can be treated as transaction costs business pays for the possibility of using transaction goods provided by the state, i.e. for the access to the legal environment in which market transactions take place. Operating in the legal environment allows business to reduce transaction costs related to market transactions due to the use of formal institutional infrastructure and means of contract enforcement which are more effective and efficient than those in the informal sector. Thus, taxes represent part of overall transaction costs incurred by business. If the payment for the access to the legal framework exceeds the benefits of using it, business may leave the formal sector for the shadow economy.

The transaction cost approach can also be successfully used to describe and analyze the costs of the business-government interactions with regard to paying/ collecting taxes. Tax transaction costs are divided into administrative costs, borne by government, and compliance costs, borne by business.

The probability of compliance is affected by a large number of economic and noneconomic factors, including tax transaction costs and tax morale, and in turn can affect the level of tax transaction costs - the lower the probability of compliance is, the higher the controlling and enforcement costs must be to secure sufficient tax revenue.

It is important to have reliable instruments for estimating the level of tax transaction costs and tracing its dynamics. Essentially all empirical studies of tax transaction costs can be divided into cross-country surveys placing emphasis on comparing tax transaction costs in different economies and providing benchmarks, and country-specific surveys representing more detailed studies of tax transaction costs for a certain economy, including estimates of the absolute monetary value of transaction costs. Differences in measurement methodologies lead to significant discrepancies in the estimates of magnitudes of tax transaction costs.

According to the Doing Business (Paying Taxes) annual surveys, since 2004 Ukraine has made a significant progress in reducing tax compliance costs, one of the reasons being the introduction and development of electronic filing procedures.

As there is a positive correlation between the overall ease of doing business and the ease of paying taxes in particular, and country's economic performances, tax reforms in lower income countries must be aimed at reducing tax transaction costs. However, reducing tax transaction costs is not an end in itself. Tax transaction costs should not be reduced at the expense of sacrificing tax revenues, fairness and flexibility of the tax system.

No tax system exists by itself. It is tightly integrated into the socio-economic system of a society, depends on economic policies and societal values, must balance the interests of numerous stakeholders, and that is why designing or modifying a tax system involves multiple tradeoffs. Building a congruent and efficient tax system must be based on a thorough understanding of various aspects of taxation, which can be studied using different theoretical approaches, including the transaction cost theory approach.

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