The Psychology of Money and Public Finance_7 pot

Psychology of Taxation and Public Finance Section 5.1 ‘Fiscal psychology: a new branch of public finance’ was first published in National Tax Journal, 12 1959, pp.. 73–9.Section 5.5 ‘Tax

Economic theory has long assumed that entrepreneurs always exercise

a maximum of rationality – that is, conscious, critically reflected actionstrictly in accordance with the rules of the optimization principle Thisassumption of the objective rationality of entrepreneurial actions can,however, hardly remain unchallenged In particular, decisions aboutthe future necessarily lack the complete knowledge and anticipation ofpossible consequences that result from each choice Since consequencesare in the future, imagination has to replace the want of actual experi-ence in their assessment

Objective rationality would require a choice between all possible lines

of evaluated action; in reality only a very few of all the possible atives are considered Added to this is the limited human capacity

altern-to process information In relation altern-to the quantum of problems thatwould need to be solved for the realization of an objective and rationalbehaviour, such capacity is remarkably small

In the centrally planned economy that has nationalized enterpriseand eliminated every business concern for correct investment andproduction decisions, a staff of officials struggles with more luck thanjudgement to reach its bureaucratic but nevertheless entrepreneurialdecisions These officials may be talented, loyal, diligent and completelycommitted Unlike, however, the market entrepreneur their viability

is not personally dependent on the accuracy of their prognoses anddecisions Nor are they tied with all the threads of their consciousness

to the ‘business’

Above all in the centrally administered and centrally plannedeconomy, there is not a real, automatically functioning organ or mech-anism of feedback Wrong decisions on investment and allocation maypossibly emerge only years after, when the length of customers’ queues

in front of the state-owned shops stretches unendingly An tarian administration is also notoriously reluctant to accept complaintsabout supply deficiencies This position is aggravated by the difficulties

authori-of establishing individual responsibility let alone accountability amongthe entrepreneurial bureaucrats

Contemporary systems theory gives a central recognition to thecybernetic or feedback mechanism of automatic control, as explainedabove Though the language is less technical, the history of the idea

in economics goes back to Richard Cantillon He first recognized anddescribed the specific role of the entrepreneur in the market economybased on a division of labour; and he saw clearly the corrective signals

of the market to the entrepreneur in his Essai sur la nature du commerce

en general, published in 1775 Adam Smith, curiously enough, did not

Jeremy Bentham in his open letter Defence of Usury turned against this

puritanical view of his friend, Adam Smith Bentham pointed to theuninterrupted progress of the general wealth in England and asked thequestion: to whom is this owed in the first instance? He emphasizedthat it was precisely the new ‘projects’ and their creators, attacked bySmith as ‘projectors’ and ‘prodigals’, who had presented England withthis new wealth by managing ‘to struggle through obstacles’, developingnew ideas and affecting progress and improvement in pursuance of theirpersonal aspirations to make money

This aspect of the process of economic innovation with its tions and consequences for the discovery of new markets, new needs,new methods of production and new outlets is taken further by Joseph

precondi-Schumpeter, the Austrian-American economist, in his Theory of Economic Development For Schumpeter the nature of the entrepreneurial function

lies in the special role of leadership

In Schumpeter’s analysis the entrepreneur becomes the decisive

‘motor of innovation’ As such, and as the pillar of economic andtechnological progress and therefore of economic development, theSchumpeterian entrepreneur truly forms a fourth factor of productionalongside land, labour and capital The consequential breakthrough ineconomic analysis does not limit itself to the discovery of abstract ‘laws’

of economics and quantitative mechanics but makes the behaviour ofentrepreneurs and the formation of entrepreneurial decisions the centralsubject matter

It is, however, an open question as to the extent and degree thatcontemporary entrepreneurs meet this special leadership role and serve

as motors of innovation Empirical research suggests that at least forEurope fulfilment of this function leaves a lot to be desired In ourCologne Research Institute an investigation in 1966 on the contribution

of small and medium-sized firms chose France for a survey that, inter alia, analysed entrepreneurial readiness to accept and carry out technical

innovation Results were very disappointing

Only about a half (53 per cent) of the questioned entrepreneurs ofsmall and medium-sized firms stated that they would frequently try outnew methods; the rest more or less preferred the old ‘proven’ methods

It made little difference to which sector the individual entrepreneursand their firms belonged It does, however, seem to depend on type ofeducation and size of firms This suggests that the special leadership role

is not inherent but rather that the entrepreneur himself has to be madeaware through appropriate education including information Beyondthis, the entrepreneur is obviously only prepared actually to take onthe role of innovator if the attached economic risk appears bearable,considering the size of his firm

A further condition is likely to be that the entrepreneur concernedhas to display a basic positive attitude towards risk; and he has to regardthe entrepreneurial activity as an opportunity for self-fulfilment and as

a worthwhile task But he must not see risk as a pressing burden, as didabout one-third of the French entrepreneurs questioned

These results cannot simply be transferred to German business, butalso the claim that in Germany the exact opposite is true, can hardly

be substantiated Spectacular single entrepreneurial innovations, as forinstance the Wankel engine or the PAL colour TV system, are in them-selves certainly not sufficient to provide the proof In a very rapidlychanging world, the long-term dynamics of the economy are decisivelydependent on the special innovatory leadership role being generallyfulfilled Ideological dogmatism would seem to inhibit and prohibitany such role contribution in centrally planned systems, much as suchsystems may try to orientate themselves towards the market

In Europe the denigration of, and smear campaign against, the preneur comes, furthermore, in a period characterized by the erosionand disappearance of historically established values

entre-‘As useless as the aristocracy’ was the leading question the magazine

Capital put to the historian Golo Mann; and in the same issue F.J Straub

was asked to comment on whether entrepreneurs, because of their flightfrom taxation, could be dubbed ‘unpatriotic’ This kind of journalism

The Entrepreneur 155

seeks to make its own contribution to the already far advanced tion of the ’myth’ of the patriarchal, once prestigious entrepreneur Inhis place in executing the feedback function of the market system isput the impersonal large enterprise with its anonymous executives or,worse, as presented in the mass media, as a naive non-comprehension

demoli-It is no surprise, then, that at least in Europe ‘the entrepreneurs’ aremade to feel insecure and are searching for a new identity There isthe danger that they may resign themselves to an increasing neglect

of their still indispensable function, especially in the changed socialpecking order Instead they may prefer to enter into an unholy alliancewith their natural opponents, the trade unions, to dilute and eliminateinconvenient competition – and thereby seriously endanger the marketeconomy

In this environment of ignorance and hostility, the entrepreneurs andtheir executives have still to fulfil their professional duties In the back

of their minds must be the sociopolitical function of the large enterprise

as well as the daily operational task, pontificates a TV programme on the

‘secret elite’ in the West German economy Entrepreneurs themselves,however, must share some responsibility for their vague and distortedpublic image On the same programme as mentioned above, a DeutscheBank spokesman said:

The managers, including myself, share the blame We do not doenough to inform the public of our work and responsibility as wesee it This is partly due to a traditional timidity and partly, strange

as it may sound, to a hesitancy to push oneself into the forefront

We must have the courage to speak out in public about our work;

we should also explain why our appearance is deceptive Here is noclique for mutual promotion of assets but on the contrary, I wouldlike openly to proclaim, a type of working elite

To establish a climate of opinion favourable to entrepreneurship in themarket economy is essential but not easy Up to now in the GermanFederal Republic, and Europe generally, only those who condemn thesystem have succeeded in mobilizing a critical but hostile public eval-uation Their global accusations indeed have the more far-reachingobjective of revolution Yet election results prove that public opinionremains unpersuaded about revolutionary change Among shareholders,investment advisers and investment clubs – where opinion-formingimpulses may originate – there is the stirring of an informed critique.Even in such groups, however, there is a hesitancy to oppose determ-inedly autocratic management that is ultimately damaging to market

entrepreneurship Occasionally criticism may be openly expressed whendividend reductions are announced at annual general meetings, thougheven then there is concern for damage to the ‘image’ or the ‘goodwill’

of the enterprise that may in the long run engender as much loss ofshareholders’ interests as reduced dividends The market economy needs

a more informed justification

In the United States there is a more sophisticated approach both topublic relations and to corporate social responsibility The search fornew ‘social indicators’ alongside quantitative growth rates in GNP doesyield concrete measures in place of image consciousness, as more andmore American enterprises reorientate values towards the quality of life.There are lessons here for German enterprise and German entrepreneurs

Psychology of Taxation and Public Finance

Section 5.1 ‘Fiscal psychology: a new branch of public finance’ was first

published in National Tax Journal, 12 (1959), pp 340–5.

Sections 5.2 and 5.3 are translated from Günter Schmölders, politik, 3rd edn, Berlin, Heidelberg, New York: Springer, 1970, pp 323–48 Section 5.4 is translated from Günter Schmölders, Das Irrationale in der öffentlichen Finanzwirtschaft: Probleme der Finanzpsychologie, Hamburg:

Finanz-Rowohlt 1960 (Finanz-Rowohlts deutsche Enzyklopädie 100), pp 73–9.Section 5.5 ‘Tax mentality in international comparison – an overview’was first published under the title ‘Survey Research in Public Finance –

a Behavioral Approach to Fiscal Theory’ in Public Finance, 25 (1970),

pp 300–6 The last paragraph was turned into a footnote by the editors.Section 5.6 ‘A theory of incentive taxation in the process of economic

development’ was first published in Il Politico, 31 (1966), pp 788–800.

5.1 Fiscal psychology: a new branch of public finance∗

I

Two important results of some 1958 surveys conducted in Germanyunder the auspices of the Cologne Centre of Empirical EconomicsResearch in the new line of research on fiscal psychology are: (1) thatfiscal policy, the idea of deficit spending in a depression and surplushoarding in a boom, has hardly any chance of practical application

∗ Dr Schmölders is Professor of Public Finance at Cologne University, Germany.

As early as 1932, he started research work on human behaviour under taxation; today he heads the Cologne Institute of Public Finance and the attached Centre

of Empirical Economics Research.

157

because of the general lack of understanding among members of ment and administrators of the underlying economic and monetaryprocesses; and (2) that ‘tax-dodging’ is something quite unfamiliar to

parlia-90 per cent of the German population

For the first time in history, a representative sample of a wholenational parliament, the Deutsche Bundestag, was tested by modernmethods of opinion research as to the economic knowledge of itsmembers (67 interviews) In addition, all the members of its financecommittee were also examined (27 interviews) At the same time, theattitude of the general public towards taxation was analysed in a modernsurvey investigation, carefully conducted by one of the leading public-opinion research institutes of Western Germany Even this latter type

of research, digging down deeply into the motivational and emotionallayers of the mind of taxpayers and other citizens, seems to have noprecedent in traditional public finance

In the Old World, the roots of this new branch of public finance

go back to the Machiavellian philosophy of public law Working alongthese lines, some Italian authors developed, at the turn of the century, apolitical theory of government finance, based largely on highly cynicalconcepts of political and administrative power.1 One of these authors,Amilcare Puviani, Professor of Law at the University of Perugia, evensucceeded in writing a complete ‘theory of fiscal illusions’, in which

he contrasted the illusions of taxpayers concerning the noble motives

of their rulers with the illusions which the latter held about the loyalfeeling of their subjects.2 In simple hedonistic terms of satisfactionand dissafisfaction, Puviani described most of the phenomena modernfiscal psychology embraces These include ways of camouflaging taxa-tion under other names, or levying taxes under conditions under whichthe taxpayer is inclined to minimize or even fail to perceive any burden,e.g death duties imposed upon heirs Further, he dealt with the skilfulmisuse of noble feelings like patriotism, confidence and religious faiththrough the issue of public loans which later might not be repaid, or,

if repaid, only in depreciated money Taxpayers’ reactions against suchfiscal tyranny, including some comments on the social background ofrevolutions, were also systematically recorded by Puviani years beforemodern psychology or social psychology had been developed

Italian Fascism and German Nazism, though broadening the field ofexperiences, did not permit scientific research along these lines Only afterthe Second World War was it possible to recount such experiences and toformulate in terms and categories of modern psychology the conclusionsdrawn from Mussolini’s fiscal measures and Dr Goebbels’ propaganda

Psychology of Taxation and Public Finance 159

It is hardly necessary to point out that many of the more traditionalrules and principles of public finance are rooted in genuine, if primitive,knowledge of human behaviour As early as 1728, Jonathan Swift hadpointed to certain limits to the raising of customs duties on non-essentials.3Even Adam Smith’s famous basic principles of taxation weremeant to protect the taxpayer against fiscal arbitrariness and injustice.Smith, for some time a customs inspector, knew much about the weak-ness of human nature under the temptations of power In the course

of the nineteenth century, French public finance derived some generalprinciples of budgeting from the same experience.4 The principles ofpublicity, of completeness, specialization, and truthfulness in budgeting,for instance, are only so many mirrors reflecting suspicion of theintegrity, good faith and fairness of an administration

Even the economic effects of taxation in general, and of income tion in particular, have been analysed in certain behavioural aspects bytraditional public finance The British economist, A C Pigou, developedhis so-called ‘tax announcement effects’ by showing that taxpayers’ reac-tions against a new tax quite logically start long before the tax is actuallylevied.5Fears of loss and expectations of possible profit are among thefactors that lead businessmen to premature reactions from tax altera-tions, which have only been proposed or suggested

taxa-It was only a small step from that development for modern fiscalpsychology to penetrate more systematically into taxpayers’ motiva-tions and reactions Resistance against, and evasion from, taxation werestudied not only in the field of the income tax, but even in the area ofexcise, sales and outlay taxation and customs duties For, even if taxa-tion as such passes unnoticed by the final taxpayer, in so far as the tax isincluded in the price of the commodity, the elasticity of demand for theproduct becomes the decisive factor limiting its fiscal results But what

is elasticity of demand? It is, after all, nothing more than a psychic (oreven physiological) measure of the urgency of wants

The main task of fiscal psychology remains, however, to analyse thedirect resistance to direct taxation of individuals and nations according

to their general ‘tax mentality’ Such tax mentality can be shown to differwidely between different peoples of Europe Whereas, in the Latin world,the word ‘tax’ means something felt as an ‘imposition’ upon the citizens

(impôt, imposto, impuesto), the German word, Steuer, means ‘support’ and the Scandinavian, skat, the common treasure destined for common

purposes On the basis of such different national tax mentalities, whichare closely connected with the citizens’ community-mindedness ingeneral, individual tax-mindedness develops by personal experiences

Confronted with the obligation to pay, the taxpayer feels inclined to acertain degree of resistance, leading to evasion, tax-dodging, or even toopen revolt, like M Poujade and his followers in France.

In order to measure the degree of individual resistance to direct tion, two ways are open to the researcher depending upon his access

taxa-to the individual cases Measuring tax compliance means taxa-to assess, byvoluntary cooperation of the taxpayers involved, the correct amount oftheir statutory tax obligation Compared with the actual amount paid,

a percentage of tax compliance can be determined In the United States,some experimental research along these lines has been done by Harold

M Groves6and G.F Break.7The compliance ratio of rent income (ratio

of reported net rent to estimated net rent) varied, according to Grove’sWisconsin study, between 17 per cent (renter subletting) and 78 per cent(garages) with an average of 51 per cent The compliance ratio of farmincome was between 46 per cent (poultry and eggs) and 86 per cent(dairy products), and averaged 75 per cent Non-compliance by farmers,however, seems to be greater than these figures reveal because of heavyoverreporting of farm expenses deductible from reported income Forincome other than rent and farm income, similar investigations remain

to be carried out

In most cases, this way will be closed to further research by lack ofcooperation on the part of taxpayers or tax-dodgers Then, the onlyother way of measuring the degree of negative compliance or tax resist-ance is to compose a true picture of the tax-mindedness of people byascertaining its elements There are certain relations between a person’scommunity-mindedness, generosity in family, club or social matters,understanding of and cooperation in public affairs, and personal readi-ness to comply with the painful common obligations of a similar nature,such as taxpaying Patterns of general tax mentality are discernible onthe basis of neighbourhood, social class and profession to which thetaxpayer belongs In other words, the individual citizen or householdcan be enmeshed in a net of admissions that will add up to a truepicture of his personality as a taxpayer If this so-called projection test isapplied, the victim can even be brought to confess his secret opinions

on tax-dodging (by others!) and his personal feelings about tax-dodgers

as social companions, business partners, or members of his family

II

A survey concentrating on such a many-sided analysis was conducted,

as mentioned above, in the early summer of 1958 in Germany.8 The

‘defendants’, a large representative sample of citizens from all walks of

Psychology of Taxation and Public Finance 161

life, were cross-examined by experienced interviewers regarding theirgeneral tax-mindedness, their moral assessment of tax-dodging and offiscal administrators and tax officials Through most of the interview,the person being questioned had no idea what it all was about Afteradmitting his viewpoint on the giving of gifts to others, on the assuming

of responsibilities – by family members and more remote relatives, clubmembers, room- and work-mates, or strangers, etc – he was asked: ‘Is,

in your opinion, the so-called church tax really a tax? Or how wouldyou prefer to define it?’9

Most people likened the church tax, which is levied in Germanytogether with the income tax and by the same authorities, more to a taxthan to a voluntary contribution or a fee

The interviewer could then turn inconspicuously from this question tosome more on the difference between taxation and fees, and voluntarycontributions Tax-dodging was introduced in quite neutral terms: ‘Arethere many people, in your opinion, willing and able to keep the fiscalauthorities from collecting something legally due them?’ The personinterviewed was asked to decide on one of two possible viewpoints ontax-dodging: Would he accept or reject a tax-dodger as his businesspartner, son-in-law or cashier?

Most people compared tax-dodgers neither with criminals nor withcommon-sense folks, but with clever businessmen But tax-dodging wasunfamiliar to most of them For 90 per cent of the German population,income tax is withheld at the source together with social security taxes,church tax and other deductions Only businessmen and the professionswere held able and willing to dodge their taxes These groups, in turn,blamed farmers (who actually are practically exempt), but could nothelp being caught on slippery ground themselves Another investigation

is planned to concentrate on these groups, whose representation inthe general population sample naturally was not sufficient for exactconclusions

III

Another hunting-ground for fiscal psychology is decision-making inparliament, particularly in matters of fiscal law and policy While inthe law field enough experts are at hand (many members have comefrom the bar or from high functions in administration), questions offiscal policy do not find competent answers in the German Bundestag.This was proved by a survey concentrating on the unique experimentmade involuntarily by the federal government during the years 1953–58when a budget surplus was accompanied by a cash accumulation

which was later dissipated.10 Rearmament was planned and budgetedaccording to Germany’s international obligations But due to difficulties

of a more technical nature (like time lags in building and deliberationsabout weapons) several billions of marks could not be expended in time.These formed the nucleus of a government hoard which accumulatedevery year up to a total amount of nearly 7 billion marks ($1.7 billion) Inthe business world, this accumulation of tax money was criticized quiteopenly Some experts compared, somewhat misleadingly, the govern-ment hoard with the famous war treasure of the Bismarck Reich, depos-ited in an old tower of Spandau fortress called ‘Juliusturm’ Even morecriticism was directed at the Ministry of Finance, when, amid a businessboom and under full employment, the hoard was dissolved and used for

a host of new (and permanent!) expenditures As the billions of ment money had been kept in the Central Bank, their expenditure wasnothing but creation of money or ‘deficit spending’ in the face of fullemployment and a general boom

govern-Very few, if any, of the members of parliament confronted withthis somewhat complex problem passed the interviewers’ examination

on its monetary and economic background Most answers disclosedvery little knowledge or understanding of fiscal–monetary relations, theeconomic consequences of deficit spending in a boom, or even the differ-ence between budget and cash expenditures On the contrary, many ofthe respondents appeared eager to vote new and bigger expendituresaccording to a long list of priorities When asked how they intended

to cover such expenditures, the answer was mostly ‘by cutting otherbudget items’ Logically, this would mean either the politicians’ neglect

or disapproval of former decisions of their own, or a strong preferencefor ‘new’ instead of ‘old’ functions of the government Psychologically, itonly betrays some of the laws of political thinking and decision-making.These laws seem to include a strong inclination towards impressivecatchphrases and stereotypes as well as quite uniform reactions to some

of the more emotional issues The question whether there still exists realpoverty in Germany to a considerable degree was mostly answered in theaffirmative, notwithstanding a nearly unanimous approval of the catch-phrase ‘economic miracle’, and the admission that even the little fellowshad duly participated in it Even the catchword ‘Juliusturm’ confirmedthese laws of political thinking very convincingly Everybody knewsomething about the Juliusturm and criticized its accumulation Suchcriticism, in the minds of politicians, was bound to assume the form ofapproval for the hoard’s immediate dissolution Only one or two of thepoliticians interviewed had some doubts about the timing of the added

Psychology of Taxation and Public Finance 163

expenditure For the overwhelming majority, any such distant monetaryand economic consequences of the creation of money in the midst offull employment seemed completely unworthy of consideration

On the other hand, the practical impossibility of keeping a ment cash surplus in the face of expenditure-prone politicians wasconceded without hesitation A very impressive slogan ‘cash ticklesdesire’, circulating during the year before, had done much to impressminds, even if not to alter decisions

govern-Political thinking, after all, follows quite different channels fromeconomic fiscal–monetary thinking or thought It is prone to suggestivecatchphrases and mental contagion It appreciates new ideas more thanapproved methods and emotional more than logical issues It seems,therefore, of little use to confront our politicians with issues of suchcomplex nature as the fiscal-policy programme Such issues will have to

be broken down into simple, elementary truths and impressive formulas

of action before politicians are asked to decide on them To develop suchformulas or, at least, to hit upon plausible slogans will become one ofthe future tasks of public finance as well as economics The new branch

of fiscal psychology seems fit to help understanding and preparation forsuch a task

IV

In the meantime, a number of other jobs wait to be done by fiscalpsychologists In France, where Henry Laufenburger has alreadyincluded fiscal psychology in his standard textbook on public finance,11

a new theory of economic thresholds has been developed by ProfessorReynaud of Strasbourg.12 Founded on fiscal experiences with tax resist-ance that starts only after a certain threshold of unnoticed taxation hasbeen surpassed, an analogy is drawn even to currency depreciation Notunlike taxation, creeping inflation remains more or less unnoticed bymost people for quite a time – until a certain degree of money depre-ciation has taken place Then suddenly a threshold of sensibility will

be reached, when all become aware of rising prices everywhere Fromhere, close connections can be established with the late Albert Aftalion’spsychological theory of foreign exchange rates pointing to some meta-economic factors of price formation in the foreign exchange markets.Psychological analysis can help in explaining many phenomena ineconomics as well as in public finance

In its own field, fiscal psychology proper will have to analyse furtherthe market conditions for public loans, the financial credit of publicauthorities, and to develop rules when to turn to loans instead of taxes

and vice versa The new instrument of moral persuasion, once restricted

to central bank policy, has to be at the disposal of fiscal agencies aswell Besides, the whole area of the public relations of government assuch, as distinct from the changing actors on the political scene, needsexploration in terms of social and individual psychology

In order to learn from other peoples’ experiences, internationalcomparisons of tax mentality, inflation sensibility and similar psychicbackgrounds of financial activities must be carried out

5.2 Tax morale and tax resistance

In the centuries-old debates about taxation, many facets of the ments reflect the experience that both for taxation in general and atthe level of each individual tax, there is a quite specific upper limit

argu-in the form of its reasonableness, argu-in psychological terms The sense ofjustice of the person liable to pay tax triggers an understandable dislike

of punitive rates of taxation for individual taxes as well as for the overalltax burden – though this response, admittedly, varies from age to ageand from country to country

The psychological threshold above which a further increase in taxrates is felt to be intolerable has therefore generally always been seen assomething entirely subject to variation In the nineteenth century, thislimit was deemed to be reached at 10 per cent, roughly the equivalent

of the ancient ‘tithe’ or ‘tenth part’;13in around 1900, P Leroy-Beaulieudescribed a tax burden of 12–15 per cent of income as the upper limit

of what was reasonable; J Popitz thought that the psychological upperlimit for taxation was one-third of income, and current [1960s, ed.]American public finance theory described 50 per cent and over as the

‘psychological breaking point’ – defining the point at which taxpayersstill have the feeling that they are working to line their own pocketsand not mainly for the benefit of the taxman In the intervening period,income tax levels in the UK and in the USA have themselves been raised

to peak rates of 90 per cent and above; and in the Federal Republic ofGermany, too, the rate of income tax has risen progressively at times toclose on 90 per cent, without triggering dramatic consequences

To date, public finance theory has engaged relatively little with thisnoteworthy set of circumstances; in his pamphlet published in 1728,the Irish satirist Jonathan Swift used the example of the taxes on silkand wine to demonstrate that ‘in the business of heavy impositions, twoand two never make more than one’.14He attributed this phenomenon,familiar from as far back as the Middle Ages, mainly to the fact that high