Does procedural justice in a tax audit situation affect taxpayers’ acceptance of tax audit assessments?

ABSTRACT

This study examines the effects of procedural justice and authority power on corporate taxpayers’ decisions to accept tax audit assessments via an experiment related to a hypothetical tax audit. We find that authority power but not procedural justice increases corporate taxpayers’ acceptance of tax authority decisions in a tax audit situation. However, when authority power is low, there is a significant effect of procedural justice in a tax audit on taxpayers’ aggressiveness in their decisions to accept tax audit assessments. According to the results, a combination of policy measures that enhance procedural justice and traditional deterrence measures warrants consideration to increase overall corporate tax compliance.

KEYWORDS:

• Procedural justice
• authority power
• tax compliance
• tax aggressiveness
• tax audit

JEL CLASSIFICATION:

• C91
• D91
• H26

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ We appreciate comments on an earlier version of this paper from Tisha King, a discussant at the 2021 American Accounting Association (AAA) annual meeting, and G-Song Yoo, a discussant at the 2021 Korean Accounting Association (KAA) Summer Symposium. We also thank the participants at the 2021 Korean Accounting Association (KAA) Summer Symposium and the 2021 American Accounting Association (AAA) annual meeting.

² In this study, we use the terms ‘procedural justice’ or ‘procedural fairness’ interchangeably.

³ In this study, the aggressiveness of taxpayers means the tendency to deal in an ambiguous situation in a way that is favourable to the taxpayers. As a result, the higher the aggressiveness, the lower the tax compliance.

⁴ There are similar rules to protect taxpayers’ rights in the Framework Act on Local Taxes. The National Tax Collection Act also lists some of the rights of taxpayers.

⁵ More details are described in the section ‘III. Research method’.

⁶ Although the concept of tax compliance is complex and hard to define, its wide-ranging definitions largely boil down to complying with the tax administration or the requirements of tax laws. In general, tax compliance research deals with complying with tax laws and rules concerning tax returns or paying taxes on time. However, whether taxpayers accept tax audit assessments or appeal against them is also related to tax compliance intention (Niesiobedzka and Kolodziej 2019, 2020). We conducted an experiment involving hypothetical tax audit situations where both procedural justice and authority power serve as critical factors, so as to effectively measure the effects of power and procedural justice. While taxpayers are dealing with auditors over a relatively long period of time under a tax audit, they form the perceptions of procedural justice. The level of tax compliance by taxpayers can be identified by examining how the procedural justice perceptions are immediately (without a long time lag) reflected in the decision of the taxpayers to accept or appeal against tax authority decisions in a hypothetical tax audit situation.

⁷ Corporate taxpayer responses to the survey are likely to be emotional or biased by their subjective judgements as they might have encountered delays or issues hampering their day-to-day business operations due to the behaviour or assessment of tax auditors during tax audits. On the other hand, tax advisors can be more objective in a tax audit situation or in deciding on whether to accept or appeal against tax decisions based on their professional knowledge and experience in responding to tax audits, not swayed by firm-specific circumstances or personal emotions.

⁸ As tax advisors are outcome driven, the results obtained in an experiment involving tax advisors may be less prominent than those derived from selecting taxpayers as participants. That is, the use of tax advisors may weaken our ability to detect the effect of procedural justice on the audit acceptance. However, such conservative results do not lead to type II error in the case where the result is biased.

⁹ We selected managers or higher-level tax professionals to ensure that all participants had a lot of experience, knowledge and expertise in tax audits. In our sample of participants, the average tax experience was 13.6 years, and the minimum experience was three years.

¹⁰ In our experiment, we chose the management service fees paid to overseas affiliates as a main issue for our hypothetical tax audit scenarios, which is of high importance for analysis in our study. The deductibility of the management service fee paid to an overseas affiliate is regarded as an ambiguous and controversial tax issue because it is almost always difficult for a corporate taxpayer to justify the benefits earned from the management service fee and/or to provide factual evidence. The Korean tax authority tends to deny it unless supporting documents and evidence are verifiable objectively, even if corporate taxpayers compute the amount of reasonable consideration for management service performed on the basis of internal and external tax filing advice, guide and support, and do their best to prove the reasonableness of the consideration. If we use an unambiguous or obvious tax issue (whose reporting accuracy and reasonableness can be clearly determined), auditors’ knowledge of tax laws and experience or authority power may affect taxpayers’ trust in the tax authority, which raises concerns about the possibility of the interaction between the two manipulated variables.

In addition, when manipulating power, we depicted in the tax audit scenarios that the tax auditor is highly experienced in responding to the management service fees-related tax audits with the high chance of winning relevant appeals, not that the auditor has extensive experience and expertise covering a wide range of tax laws and tax audit activities. These competence and expertise, limited only to tricky and special situations like those involving the management service fees paid to overseas affiliates, differ in nature from the broad, abstract competence and expertise of the tax authority that would affect the psychological factors of taxpayers. This scenario setting would keep under control the effect of the power manipulation on the perception of procedural justice, which is the other manipulated variable.

¹¹ By presenting the tax audit situation with the same levels of proper tax filing and substantiation to all participants, we could control the effect of participants’ judgements on the reasonableness of the reported amount on the results of the analysis.

¹² More details of the manipulation of the independent variables are provided in the Appendix.

¹³ This study differs from existing studies measuring only a partial aspect of procedural justice (e.g. Niesiobedzka and Kolodziej 2019; Van Dijke and Verboon 2010; Worsham 1996) by comprehensively incorporating all of Leventhal’s (1980) six rules in our hypothetical scenarios. According to Van den Bos, Lind, and Wilke (2001), people tend to form the perception of procedural justice through not just a few but many facets of a process. Therefore, this study examines the effect of the holistic perception of procedural justice by concurrently manipulating the six procedural justice rules outlined by Leventhal’s (1980) in a realistic tax audit situation.

¹⁴ More details of the measurement of the dependent variables are provided in the Appendix.

¹⁵ When all control variables (e.g. gender, age, risk preference) are included in the analysis, none has a significant effect on the dependent variable. Therefore, we present the results of ANOVA with the two independent variables only.

¹⁶ RISK PREFERENCE is measured by a question used in Young’s (1985). The risk preference ranges from 0% to 100%. The higher the risk preference, the more risk avert the participant. We categorize 25 responses with less than 50% RISK PREFERENCE into the ‘Risk Seeker’ subsample, 53 responses with 50% RISK PREFERENCE into the ‘Risk Neutral’ subsample, and 57 responses with more than 50% RISK PREFERENCE into the ‘Risk Averter’ subsample.

¹⁷ Several fit indices are examined to test the fit of the model. RMSEA and SRMR are zero and CFI and TLI (NNFI) are one in the path analysis for all subsamples. The models show good fit based on these indices.

¹⁸ For robustness, we performed ANOVA using risk preference as a continuous variable. The ANOVA confirms a statistically significant increase in the effect of POWER on ACCEPTANCE when participants’ propensity towards risk is more tilted to one direction (untabulated). In other words, when participants consider risk factor as an important determinant of decision-making, the effect of power on the acceptance level is larger. This result is in line with our inference that the perception of authority power relates to the perception of the risk of detection by the tax authorities.