In 1776, Adam Smith, the father of modern economics, observed in his seminal work The Wealth of Nations that “the subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities.” This timeless insight, however, seems to be lost in translation in modern-day India. As the Union Budget 2024-25 looms on the horizon, several quarters wants the direct taxes to go down. However, this column is not about those fiscal tweaks. It delves into the larger philosophical question: why do people pay or evade taxes?
People desire better infrastructure — roads, railways, airports — but balk at the idea of higher taxes to fund these improvements. While people crave the benefits of development and progress, they resist the immediate cost of taxation, hoping someone else will bear the burden.
This disconnect results in a paradox: the public demands enhanced public services and infrastructure but is unwilling to contribute proportionately. This reluctance is evident in the strikingly low number of tax filings in India, where only 8.18 crore individuals filed income tax returns for the assessment year 2023-24 as of December 31, 2023, a trivial figure for a nation of over 140 billion people. Many of these filings even reported zero returns, highlighting the pervasive issue of tax evasion and the challenge of fostering a collective sense of fiscal responsibility. This is a significant improvement from AY 2013-14 (3.36 crore). The net direct tax collections also grew grew 9.8 per cent to ₹4.62 trillion till mid-June. But even this is not enough.
The problem of tax compliance becomes even more pronounced as one moves from the Union Government to State governments, and finally to local governments. As the level of government becomes more localised, tax compliance tends to decrease. People who would never dream of evading national taxes might casually skirt around their obligations to local authorities.
State capacity is a significant factor in this dynamic. Before exploring the broader implications, let’s examine the common reasons behind tax evasion. Tax evasion is a complex phenomenon influenced by various philosophical, economic, and psychological factors. According to Rational Choice Theory, individuals weigh the costs and benefits of their actions and make decisions that maximise their utility. Gary Becker argued that people engage in illegal activities, including tax evasion, when the expected benefits outweigh the expected costs. If individuals perceive the risk of being caught and punished as low and the financial gain from evading taxes as high, they are more likely to evade taxes.
The social contract theory, rooted in the works of Thomas Hobbes, John Locke, and Jean-Jacques Rousseau, suggests that individuals agree to form a society and abide by its rules, including paying taxes, in exchange for protection and benefits provided by the state. However, when individuals perceive the state as corrupt, inefficient, or unjust, they may feel morally justified in evading taxes. As philosopher John Stuart Mill noted, individuals may resist taxation if they believe the government is not using their money effectively or ethically.
Psychological theories suggest that people’s attitudes towards taxes are influenced by fairness, trust in government, and social norms. Richard Thaler and Cass Sunstein’s concept of ‘Nudge Theory’ highlights how small changes in policy design can influence behaviour.
When people perceive tax policies as unfair or feel that others are also evading taxes, they are more likely to engage in tax evasion themselves. This aligns with the concept of “conditional cooperation”, where individuals’ willingness to comply depends on the behaviour of others.
Intricate relationship
An alternative explanation for why people pay taxes can be found in the intricate relationship between civicness, institutions, and state-fiscal capacity. In his paper ‘State Capacity, Reciprocity, and the Social Contract’, Timothy Besley explores the dynamics that foster a culture of tax compliance. Besley’s model highlights the importance of reciprocal obligations where citizens pay their taxes and the state provides public goods. This reciprocity forms the bedrock of a robust social contract, where citizens agree to fulfil their tax obligations in exchange for the benefits of a well-functioning state.
Scholars such as Besley, Levi, and Putnam argue that civic culture and social capital are critical for the emergence and maintenance of efficient states. When citizens trust their government and believe that their taxes are used effectively for public goods rather than being siphoned off by corrupt elites, they are more likely to comply with tax laws. This trust and civic engagement create a virtuous cycle, reinforcing the social contract and enhancing state capacity. However, if citizens perceive the government as inefficient or corrupt, this trust erodes, leading to higher levels of tax evasion and a weakened state capacity.
When citizens observe their local environment deteriorating — such as poor roads, unreliable water supply, or erratic electricity — they feel the social contract is broken, eroding their willingness to comply with tax obligations. This sentiment is exacerbated when they witness their tax money being squandered on populist freebies by State governments, creating a profound sense of injustice and betrayal. When governments prioritise vote-buying through freebies over genuine public goods, they not only squander public resources but also destroy the civic culture necessary for a robust state. This misuse of taxpayer money for political gains is a direct attack on the very fabric of a cooperative social contract, leading to higher tax evasion and weakening state capacity. This breach of trust fosters a vicious cycle where taxpayers, feeling exploited and unvalued, increasingly shirk their fiscal responsibilities, thus undermining the State’s ability to function effectively.
To address the crisis of tax compliance and restore the social contract, governments must prioritise long-term developmental goals over short-term political gains. Fiscal responsibility should focus on genuine public goods rather than populist freebies. Transparency and accountability in public spending are crucial for rebuilding trust. Enhancing local infrastructure and services is essential for fostering a civic culture of tax compliance. National-level improvements like highways and airports are not enough; development must be visible in local communities. Unless civic bodies and States deliver on these fronts, the development of a robust tax-compliant culture will be slow, undermining state capacity and fiscal health.
The writer is Officer on Special Duty, Research, Economic Advisory Council to the Prime Minister. Views are personal