The Conditional Effect of Political Trust on Tax Compliance

Two competing schools of thought aim to explain people’s compliance with tax laws. The economic approach views (non)compliance as driven by rational cost-benefit analysis. The sociological approach relates (non)compliance to one’s perception of government’s trustworthiness and predicts higher tax compliance in countries where there is more trust in political institutions. This paper presents an attempt to combine the two approaches. It is argued that trust’s effect on (non)compliance might change depending on the overall economic environment. More specifically, the importance of trust for compliance increases in times of economic crises. In other words, it is in times of economic hardship that we should expect the compliance gap between high and low trust societies to be particularly large. This happens because tax compliance decisions by individuals with higher trust in political institutions (and thus higher tax morale) are less affected by the changing economic costs and benefits of compliance (economic crises tend to increase costs of compliance). This argument is empirically tested in two ways. First, Lithuania's and Estonia's experience during the crisis of 2008-2010 reveals that substantially better fiscal results in Estonia can be attributed to higher trust in political institutions which in turn led to higher tax morale. Besides, the argument is also tested statistically in a large-N setting. In statistical terms, the expectation is that the marginal effect of trust on compliance is conditional on the state of the economy. The argument is tested with panel data on EU member states for the years 2000-2011. The paper finds empirical support for the argument. At the end, suggestions for future theoretical development and empirical testing of the argument are provided.