Is imposing a general tax return filing obligation in Israel the optimal tool for enhancing compliance with tax laws?
Several professional committees have in the past recommended imposing a general tax return filing obligation in Israel. The motives for this include reducing noncompliance with tax laws, changing the tax system, and improving databases. The issue was also mentioned during the past year in the course of discussions on reducing noncompliance. In Israel, the tax return filing obligation (the requirement to file an annual return with tax authorities on income and expenses during the period) applies to companies and to self-employed individuals, while most employees and the rest of the population are exempt from filing a tax return. A general tax return filing obligation would mean the expansion of the obligation to file an annual return by applying it to all employees. Currently, the employer reports employees’ income, and makes at-source deductions of the taxes imposed on the employee and transfers them to the Israel Tax Authority. This is the method generally used in about half of the OECD countries. In the rest of the OECD countries—including the US, Canada, France, Denmark and Greece—the employee must file a return with the tax authorities at the end of each year.
The need for an employee reporting obligation derives from the structure of a country’s tax system. In countries where taxation is integrated—meaning where the tax obligation is calculated based on the individual’s total income, earned and unearned—the individual must file an annual return reporting all types of income. In Israel, in contrast, income from each source is taxed at a separate tax rate, which is independent of income from any other sources. Thus, the tax rates on salary are not dependent on other income, and the tax amount is calculated and sent to the government by the employer. Unearned income is taxed at fixed rates that are generally not dependent on the amount of other income, and payment to the tax system is made at the time of the transaction or when the income is generated. The tax legislation system in Israel therefore enables the tax authorities to calculate the tax obligation and to make tax payments without the individual filing an integrated tax return. This box doesn’t deal with the question of what the most preferred tax method is. But the implementation of the integrated method requires, as noted, the imposition of a general tax return filing obligation.
Another reason for filing an annual return in various countries, other than the use of the integrated taxation method, is the existence of individual benefits for employees in respect of various expenses which can only be deducted from taxable income by filing an annual return. In Israel, the benefits in respect of expenses connected with work are granted to employees through the employer, through the credit points system that give employees the benefits without the need for filing expense documents (based on the employee’s declaration on Form 101).
Expanding the tax return filing obligation in Israel to employees will make it possible to change the existing tax system. Among the possible changes are altering the progressiveness of the tax system by instituting integrated taxation; expanding the policy of supporting working parents by deducting from taxable income childcare expenses that are actually paid; increasing the efficiency of the Earned Income Tax Credit by adjusting the credit amount to family income; and increasing the encouragement of professional development by deducting from taxable income the precise costs of academic and professional studies. Other than the worthwhile discussion of whether such changes are desirable, it is clear that reporting on its own will not be sufficient to realize them. Appropriate resource allocation on the part of the Israel Tax Authority will be necessary in order to examine these forms and prevent various fraudulent activities that the complexity of the tax system will make possible.
Along with opening up new possibilities in the tax system, imposing a general tax return filing obligation will lead to additional costs, to individuals who are currently not required to file a tax return as well as to tax authorities. In the United States, for instance, tax authorities have calculated that the estimated time required for each assessed person to fill out a tax return was about 14 hours. This is in addition to the time and resources devoted by the tax authorities to inputting the forms, only a tiny fraction of which are examined in the end. In order to reduce the expenses imposed on individuals, some countries that have instituted a general reporting obligation implement a “declarative reporting” method using a Pre-filled Tax Return, in which the tax authorities prepare the annual return on their own for each individual based on administrative data on that individual’s income. For this purpose, these countries established a central database that includes all income data received on each individual from various entities in the economy (banks, insurance companies, investment houses, and so on). Based on the information in the database, an automatic calculation of each individual’s tax bill is made, and the report is sent for the individual’s approval. This method has been instituted in full or in part in about 13 OECD countries where there is a general reporting obligation (Figure 1).
Instituting a general tax return filing obligation with a pre-filled tax return in Israel will markedly reduce the individual’s involvement in preparing the return. In order to implement it, the preparation of a technological infrastructure for online dispatch and consolidation of information from various sources, as well as legislation enabling the transfer of private information from the various entities to the tax authorities, are required. The Israel Tax Authority currently has a database that includes full information on employees’ income from work, which is based on employer reports (Form 126). It includes broad information on more than three million employees, and can serve as the basis for building a central information system that will enable the preparation of automatic tax assessments for employees. Adding in data from reports from additional entities (such as banks, pension funds, insurance companies and the National Insurance Institute), and the cross-referencing of income tax and VAT data will make it possible to automatically generate a complete annual return for each employee. The establishment of a central database can serve as a tool in the struggle against the shadow economy by specifying individuals with a high probability of noncompliance with the tax laws, by cross-referencing data from various administrative sources that serve as indicators of individuals’ income and expenses (such as merging data on real estate ownership).
Creating the technological and legal conditions necessary for establishing the central database and instituting pre-filled tax returns in Israel will take some time. Until then, the imposition of a tax return filing obligation on employees through a non-automatic method will be a heavy burden on individuals, and will lead to increased expenditure by the Israel Tax Authority. In view of the many resources expected to be expended, it is important to verify that imposing a tax return filing obligation on employees will achieve its main purpose as raised in the public discussion in Israel—reducing noncompliance with tax laws.
The literature presents a broad range of factors that influence an individual’s readiness to comply with tax laws, but there is no evidence found of the efficiency of imposing a general tax return filing obligation. The literature mentions the theory of “the trembling hand”, based in experimental economics, according to which the act of signing increases the probability that the signer will report truthfully. It is therefore possible that signing the annual return will increase the chance that individuals will report all of their income.
The rules currently in force in Israel require most of the population to declare sources of income and to sign the declaration. All employees in the economy declare their sources of income each year on the Israel Tax Authority’s Form 101, which is signed at the place of work and transmitted to the Authority by the employer. Those receiving National Insurance allowances are also required to report on their income when submitting a signed request for allowances (other than universal benefits).
A simple statistical analysis of the connection between estimates of the size of the shadow economy and the institution of the general reporting obligation in OECD countries does not indicate a correlation. A calculation of the average and median estimated size of the shadow economy in 32 OECD countries, divided into two groups—countries where a tax return filing obligation is imposed on employees (18 countries) and countries without such an obligation (14 countries)—indicates that the average estimated size of the shadow economy in terms of GDP is the same in both groups, close to 19 percent of GDP (both with median size of 18 percent of GDP). It is reasonable to assume that when the Israel Tax Authority obtains access to all of the data relevant for calculating taxes, the use of artificial intelligence to analyze and identify potential tax evaders will be much more effective than having millions of citizens sign forms.
The issue of the efficiency of a general reporting obligation in dealing with the shadow economy requires examination, in view of the significant costs that would be involved. If it becomes clear that the tool is effective, and the government decides to institute general reporting, it should be implemented in an advanced method that takes full advantage of up-to-date technological possibilities—the pre-filled tax return method. This method requires significantly fewer resources than the traditional “active” method, which requires each individual to file a yearly return.