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Explaining tax evasions: The Cobra Effect

By Sushma Nayak, Shradha Kochhar and Anubhuti Jain

‘Information’ entails essential facts about a subject that assist individuals in making rational choices. Such choices are made in conformity with the ‘minimax’ principle – minimising costs, maximising benefits.

In particular, when two parties are involved in an ‘interaction’ or ‘transaction’ and both the parties are equally informed, it is deemed to be mutually beneficial. If you intend to buy a house, you would expect the seller to share every detail about the same to ensure a fair contract. If he conceals some essential information that is detrimental to your interests, you may lose out on the deal. Thus, the consequences of uneven or asymmetric information may be costly for the less informed.

Perverse incentives: The Cobra Effect

The ‘Cobra Effect,’ was a phenomenon observed in India during the British colonial rule, which is often reckoned as a classic example of ‘perverse incentives’. The British were overwhelmed by a rising number of poisonous cobras and had to devise a policy to check this problem. Correspondingly, the government decided to reward any individual who was able to slay a cobra. Although this measure was an outright success, it gradually augmented the breeding and rearing of serpents with the sole motive of killing them for getting a reward. To curb this, the reward was withdrawn only to find that the serpents were now set free, thus leading to multiplication of the reptiles.

A major implication of this effect is the unsolicited outcome of a scheme that was initially proposed with the objective of dealing with a problem plaguing the society. Thus, any policy which is premeditated with a desirable outcome to contend with a difficulty may make things even worse.

The macroeconomic implications of information asymmetry

From a macroeconomic perspective, the case of asymmetric information can be best explained through the idea of of ‘perverse incentives’. As is well known, state actions are important in prudent policy making. It is equally true that such actions come with a series of challenges that may crop up over a period of time. Policymakers may select a program that allows the public to exploit it for their personal gains instead of benefitting society as a whole. Such deviations from the moral principles for maximisation of personal gains, exhibited by the general public, are known as a ‘moral hazards’.

It is particularly important to note that moral hazards and perverse incentives go hand in hand and certain incentives offered by the state may encourage actions that are not in the best interests of the society. The Government of India has embarked upon several programs in recent years but with limited success owing to the self-seeking activities of some beneficiaries.

Moral hazards of tax amnesties

A tax amnesty scheme involves comprehensive guiding principles concerning the immunity enjoyed by past tax evaders upon truthful reporting of incomes in the present period. The honest revelation of income or otherwise is a matter of choice at the discretion of the taxpayer and it largely depends on his estimation of possible gains or losses from such a move.

As a responsible citizen, each individual who is liable to pay taxes must do so without any special intervention from the government. However, tax evasions being rampant, the Government of India has introduced tax amnesties from time to time to prompt evaders to come clean with honest disclosures of previously undisclosed incomes. Tax amnesty is likely to discourage the public from paying taxes in the present period in anticipation of the next amnesty, which is a moral hazard. Although recent amnesties, such as IDS-2016, have brought forth heavy penalties for tax evaders, such initiatives may not be sufficient in augmenting long-term revenue or enhancing compliance.

Curtailing tax evasion in the future

Recent studies propose “evaluation research” to assess the effects of social programs and initiate future policies based on past outcomes. A close examination of previous amnesties shall assist evidence-based policy making. It is equally important to broaden the tax base. Also, lower tax rates will generate a higher revenue. As long as the tax rate is optimal, the tax revenue will rise. However, beyond the optimal rate, a rise in the taxes lowers the revenue. People don’t feel motivated to work hard when they realise that every bit of additional income leads to a higher tax burden.


Featured Image Source: The New Indian Express

Ms. Sushma Nayak is a visiting faculty member at the Symbiosis School of Economics, Symbiosis International University and Ms. Shradha Kochhar is an alumnus of the same institution. Ms. Anubhuti Jain is currently a student at the Symbiosis School of Economics.