Revised-tax-complexity-and-compliance.docx

An Analysis on the Impact of the Complexity of the Philippine Tax System on Tax Compliance in Relation to the Personal Income Tax of Self-Employed Individuals

In partial fulfillment of the requirements in Thesis 1

Submitted to: Dr. Evangeline Paraan

Submitted by: Hizon, Luis Jr. C. Lacbayan, Jonas Ysrael D. Morales, Samantha Valerie T. So, Maricar G. Tee, Andrew S. 4A8

Table of Contents Chapter 1. The Rationale and Background……………………………………………………………4 Introduction……………………………………………………………………………………….4 Background of the Study………………………………………………………………………….4 Main Objective……………………………………………………………………………………5 Statement of the Problem… ………………………………………………………………………5 Theoretical Framework…………………………………………………………………………....6 Conceptual Framework…………………………………………………………………………....11 Significance of the Study…………….……………………………………………………………13 Scope and Delimitation……………………………….…………………………………………...14 Hypotheses………………………………………….……………………………………………..14 Assumptions……………………………………….………………………………………………15 Definition of Terms……………………………….……………………………………………….15 Chapter 2. Review of Related Literature…………….………………………………………………...16 Chapter 3. Research Method……………………….…………………………………………………..27 Research Design………………………………….………………………………………………...27 Study Locale………………………………….…………………………………………………….27 Population and the Sample……………….………………………………………………………...27 The Instruments……………………….…………………………………………………………....28 Data Collection Procedure……….………………………………………………………………....28 Statistical Treatment……….……………………………………………………………………….29 Ethical Consideration….…………………………………………………………………………...29 References…………..………………………………………………………………………………31

List of Figures Figure 1 2 3 4

5 6

Title Standardization Formula Aggregated Formula Tax Effort Ratio Formula Illustration of the indicators of complexity of the personal income tax of the Philippines tax system and its effect on the personal income tax compliance of self-employed Filipino taxpayers Gunning-Fog Readability Index Formula Pearson’s r model

Page 8 9 10 11

12 29

4 Chapter 1. The Problem: Rationale and Background Introduction Introduction Background of the Study The Philippines, as a developing country, gives high priority to its economic development. As the government plans and executes a variety of projects, the necessary funding must increase over time. The government’s main sources of revenue are the taxes collected from the taxpayers. Therefore, as the Philippines reduces external funding from foreign countries, the government should increase the revenue sources that must be generated within the country. This means that the country’s government expenditures should be financed by the state’s revenues, but according to the National Tax Research Center, the taxes collected by the Philippine government have not been enough to cover the government spending since 1998. Savitri (2015) stated that tax compliance is an important factor in the realization of the government’s revenues. Tax compliance, defined by Gunadi as cited in Savitri (2015), is the willingness of an individual taxpayer to meet his/her tax obligations without the need of holding on investigation in the application of penalties and sanctions legally and administratively. It is a situation where the taxpayer meets all his tax liabilities. One of the factors that may affect tax compliance of a taxpayer is the tax system complexity. Tax complexity may arise due to the sophistication in the tax law implemented by the government. In an article in Business Inquirer, Españo (2016) stated that the current tax system in the Philippines imposes complex and repetitive compliance rules. According to the World Bank report in Doing Business 2019, the Philippines fell from 113th to 124th out 190 countries ranked in terms of ease of paying taxes in the country. In this study, the researchers aim to determine and analyze the complexity of the Philippine personal income tax system and how it affects the tax compliance of the self-employed Filipino taxpayers.

5 Main Objective As the Philippine government decides to increase the expenditures allotted on their extensive projects, the need for higher tax revenue also increases. Through various changes and reforms conducted in the tax system of the Philippines, increased complexity may arise, which in turn may affect the tax compliance of the Filipino taxpayers. The implementation of the Tax Reform for Acceleration and Inclusion (TRAIN) Law has especially added more confusion to the Filipino citizens in relation to the tax system. The main objective of this study aims to examine and analyze the effect of tax complexity of the Philippine tax system upon the tax compliance of self-employed Filipino taxpayers in relation to personal income tax. Statement of the Problem The Philippine Government continually seeks modifications and changes to the current tax system to maximize tax revenues in order to cover their expenditures. As the tax system of the Philippines changes through time, it becomes more complex, and the confusion of the Filipinos regarding the tax system increases. A complicated tax system, particularly in the view of the taxpayers, may have drastic effects in their compliance to the tax laws. In line with the given problem, this study seeks to determine the effects of a complex personal income tax system to the tax compliance of self-employed taxpayers. The study aims to determine the possible causes of the complexity, which may provide tax literacy to individuals to overcome their low tax morale and tax non-compliance to the Philippine Government. The study may also provide policymakers with a brief view of the effects of their policies. This study specifically seeks to answer the following questions: 1. What are the amounts of personal income tax revenue collection and predicted personal income tax revenue collection from 2014 to 2018, for the measurement of the tax compliance of self-employed individuals in the Philippines?

6 2. What is the relationship between the complexity of the personal income tax system and the compliance behavior of the self-employed Filipino taxpayers? 3. Which characteristics of the Philippine Tax System were found to be indicators of complexity, if found complex? 4. What is the impact of the degree of complexity of the Philippine Tax System to the compliance of the self-employed individuals? 5. What are the on-going issues and future modifications with regards to personal individual taxation that could alter the tax compliance of the self-employed individuals in the Philippines. Theoretical Framework Tax Complexity In order to determine the areas where complexities in the tax system for both businesses and individual taxpayers may be reduced, the Government of the United Kingdom (UK) created the Office of Tax Simplification (OTS) on July 20, 2010. The OTS developed the OTS index, which is a spreadsheet tool for analyzing and measuring the relative complexity of the UK tax system. This could be used to prioritize future OTS projects, as it would be possible to identify which areas of the tax system are complex. The original intention of the OTS Index was to give a single ‘star rating’ for each area of tax, but this seemed to be very simplistic and the government wanted to develop a more sensitive tool; therefore, the OTS Index previously went under three iterations in 2012, 2013, and 2015; the index to be discussed below will be that of February 2017. As indicated in their paper, the OTS’ main aim was to measure UK tax system complexity, but other countries are welcome to use it as it is universal and can be revised as willed. The index was later developed to include two figures, the underlying complexity and the impact of complexity. The underlying complexity is a measurement of the structural complexity of a tax measure, based on the policy, legislative, and operational or implementation complexity indicators. The policy complexity refers to how difficult it is for a taxpayer to understand the concept of the tax system, taking into consideration the number of reliefs granted onto the taxpayer and the number of

7 Finance Acts with changes since the year 2000. The number of tax reliefs or tax exemptions that a taxpayer enjoys has a direct relationship with the complexity of the tax system, wherein as the number tax reliefs or tax exemptions increase, the tax complexity also increases. On the other hand, the changes made in the tax code has repeatedly been recognized as one of the top contributor to the complexity of the tax system; however, the measure of how grave the impacts of the changes are, are not considered; therefore, a future refinement is yet to be done that will be able to provide the magnitude of the changes by grading each year’s changes in the tax code in terms of the new reliefs and new information that is required for a taxpayer to know. The legislative complexity refers to how difficult it is for a taxpayer to understand the legislation in terms of its readability through the Gunning-Fog Readability (FOG) Index and the number of pages of the legislation. The FOG Index is a readability test designed to show how easy or difficult a text is to read will be, this will used in order to measure the tax system’s readability by determining whether the tax legislation can be understood solely by reading it without the need for further effort, or there is a need to look for the definition of the terms used in the provision. The number of pages of the legislation may indicate the complexity of the tax legislation based on its length; as the number of pages of the legislation increases, the tax complexity decreases. The tax complexity has an inverse relationship with the number of the pages of the legislation, because a longer legislation is able to better expound the provisions in the tax code, whereas a short legislation is unable to explain its intricacy. The number of pages of the legislation complements the Gunning-fog readability index, because if the legislation has lesser pages and lesser explanations, its readability may be impaired due to the cross-referencing needed on the part of the reader. The operational complexity refers to how difficult it is to deal with the issue of complexity for the taxpayer by determining the complexity of both the guidance of the tax agency of the government and the information requirement to make a return. The availability, readability, and number of pages of the guidelines they provide may be considered in order to measure the complexity of the tax agency’s guidance, these guidelines include the manuals and the helpsheets in filling up the tax agency forms while

8 the difficulty in gathering the number of information requirements a taxpayer must meet in order to act upon their obligations is measured for the identification of its complexity. The impact of complexity is a measurement of the costs of complexity in the tax system, to both the taxpayer and the tax agency. The OTS Index provided four indicators. The first indicator is the number of taxpayers affected has a direct relationship with the effects of tax complexity; the number of taxpayers who may be considered may be affected directly or indirectly. The total cost in fulfilling their obligations or the aggregated compliance burden to the taxpayer and the tax agency is needed to be measured. The tax agency is included in order not to disregard the shifts in obligations between the two, because despite the transfer of certain obligations of the tax agency onto the taxpayers, some of the taxpayers’ obligations may be transferred as well. The average ability of the taxpayers to pay is not classified as an underlying cause of tax complexity but it is considered as a symptom of its complexity; for the lower the ability of the taxpayer, the greater the impact of tax complexity will have on them. The final impact of tax complexity may be the risk of low tax revenue due to error, failure to take reasonable care (FTRC), and avoidance. The decrease in tax revenue will affect the government’s ability to maintain public funds to finance future programs and invest in projects. The OTS Index uses a standardized formula, which scales each factor between 0 and 1.

Y1 = (Y-Ymin)/(Ymax-Ymin) Figure 1. Standardization Formula Where Y is the value of the indicator of a tax measure, Ymin represents an indicator’s lowest value across all tax measures, and Ymax indicates the highest tax measure. A score of 1 will indicate the most complex tax and a score of 0 the least complex.

The aggregation formula is much simpler. A multiplication factor is also included to stretch the index to give scores between 1 and 10.

9

(Y1+ Z1 +...n16) *10 Figure 2. Aggregated Formula Where n1 represents a normalized indicator. A score of 10 will indicate the most complex tax and a score of 0 the least complex. Tax Compliance In order for the tax revenue performance to be examined, numerous scholars have tried to use econometric techniques to measure the potential of taxation and the extent to which the tax authorities utilize this potential. This has led to the development of two key concepts in taxation studies: the tax capacity and tax effort. Taxable capacity is defined as the predicted tax revenue of a country which is estimated empirically taking into account its specific economic, demographic, and institutional features; and the tax effort ratio is the share of the actual tax revenue collection in percentage of the taxable capacity (Le, Moreno-Dodson, & Bayraktar, 2016). One of the advantages of using this measure is that it is easy to attain and it is able to provide a quick overview of the tax trends across countries. The formula for the tax effort ratio is:

te =

𝑡𝑟 𝑡𝑐

Figure 3. Tax Effort Ratio Formula Where te is the tax effort ratio, tr is the total actual tax revenue collection during the taxable year provided by the annual Bureau of Internal Revenue (BIR) reports as shown in their official website, and the tc is the projected tax revenue computed by the Database Consistency Checker as stated by the President in his State of the Nation Address. The Database Consistency Checker (DBCC) through the Executive Order No. 232 was created on May 14, 1970 which was intended primarily to review and approve the macroeconomic targets, revenue projections, aggregate budge level, borrowing level, and expenditure priorities. The targets approved by

10 the Office of the President are then recommended to the Cabinet, the President of the consolidated public sector financial position, and the national government fiscal program. The relationship of tax compliance an tax ratio was shown by Abdul Rahman (2015). He said that tax compliance is signaled by tax effort ratio; a low tax effort ratio would mean structural problems with tax compliance. A high tax effort ratio, he stated, would mean high tax compliance by the taxpayers. BIR Commissioner Cesar R. Dulay also expressed the relationship of tax effort ratio and tax compliance. According to the commissioner, the 2017 tax effort ratio never would have been able to surpass the ratio from 2016 without the help of the taxpayers. As long as taxpayers are compliant, he said, tax effort ratios would also be high. This indicates that tax effort ratio can be used as the measurement of the tax compliance of the taxpayers. The capacity of the government to collect tax revenues from its taxpayers as measured by the tax effort ratio signals tax compliance; the value of the tax effort ratio depends upon the tax revenue collections made and these collections are due to the compliance of the taxpayers.

11 Conceptual Framework

Figure 4. Illustration of the indicators of complexity of the personal income tax of the Philippines tax system and its effect on the personal income tax compliance of the self-employed Filipino taxpayers The figure depicts the main idea of the study. It shows the effect of the complexity of the tax system of the Philippines, in relation to personal individual tax, to the tax compliance of the selfemployed Filipino taxpayers. The complexity of the personal income tax will be measured using the OTS Index. The OTS Index was developed by the OTS in the UK to address the increasing complexity of tax systems not only in the UK, but also in other countries. Since the OTS index requires that some of the indicators be judged subjectively, the researchers have revised the measurement of the indicators for it to reflect an objective approach. The OTS (2017) stated that the index may be changed and divided according to the use of the index. Other studies have also utilized the OTS index, and revised it in the process, as Budak and James (2018) have. The revisions were based on different studies found. The OTS Index divided tax complexity into two parts, Underlying Complexity and Impact of Complexity. Underlying Complexity measures the structural complexity of the Personal Income Tax System. Impact of Complexity measures the costs of compliance to the self-employed individual taxpayer. Underlying complexity has three areas, namely policy, legislative, and operational.

12 Policy Complexity has two measures, which are the number of tax exemptions and tax credits, and the number of changes in the Personal Income Tax Code since 1997. The number of tax exemptions and tax credits will be measured by assessing these in the Tax Code, specifically for the area of personal income tax. For the number of changes, 1997 was chosen as the base year by the researchers because before 2018, 1997 was the year with the last major tax reform. The OTS Index has provided users the freedom to choose which base year will be best fit for the purpose. The number of changes in the Personal Income Tax Code will be measured by counting the number of revisions the personal income tax has had since 1997. Legislative Complexity is measured by the Gunning-Fog Readability Index and the length of the legislation in relation to personal income tax. The FOG Index is determined by this formula:

𝑤𝑜𝑟𝑑𝑠

𝑤𝑜𝑟𝑑𝑠

0.40 [( 𝑠𝑒𝑛𝑡𝑒𝑛𝑐𝑒𝑠)+100 ( complex 𝑤𝑜𝑟𝑑𝑠)] Figure 5. Gunning-Fog Readability Index Formula The length of legislation in relation to personal income tax does not indicate complexity directly, but it does affect the perspective of the taxpayer, which may affect compliance, according to the OTS (2017). Operational Complexity has two measures in the OTS Index. The researchers revised this area, and have determined three measures. According to Ulph (2014), Operational Complexity reflects the easiness/costliness of the process of informational, filing and payment requirements/obligations. The OTS Index indicated that one of the measures of Operational Complexity is the complexity of the guidelines given by the tax collection agency. The researchers have opted to use the Gunning-Fog Readability Index to measure the BIR guidance. The second measure of Operational Capacity in the OTS Index is the complexity of the information requirement to make a return. The measurement for this indicator was subjective. The OTS (2017) even stated that “a more objective approach may work better.” The OTS (2017) also indicated that an alternative to this measure was the number of information obligations a taxpayer is required to meet their tax obligations. Due to this, the researchers deduced that the more

13 objective way to measure this indicator was to use the number of payments needed to comply with said obligations and the hours needed to comply with the required personal income tax obligations. The Impact of Complexity in the OTS Index measured the impact to both taxpayers, and the tax collection agency. While measuring the impact to both taxpayers and the BIR would measure the tax system as a whole, it is not plausible to gather the needed data from the BIR since the data are confidential. The Impact of Complexity in this study will only measure the impact to taxpayers. It is measured by the following indicators: number of taxpayers, average ability to pay of self-employed Filipino taxpayers, and the compliance burden for a self-employed individual Filipino taxpayer. The average ability to pay of self-employed Filipino taxpayers would be based on the socioeconomic classes and the percentage of the population. Compliance burden is the cost to the taxpayers for complying with their tax obligation. The OTS Index has provided a standardized formula that will help with the simplification of the values of the indicators and allow for comparison. This formula scales the indicators into a number between 0 and 1, with 0 being the least complex and 1 being the most complex. The index has also provided an outline of a table that can be used to input the indicators. The researchers have decided that they will use the years 2008-2018 for the analysis of the relationship of personal income tax complexity and the tax compliance. A span of ten years was chosen because in these ten years, three Philippine presidents have been in power, with different ways of administration. Three Philippine presidents would mean that the tax system will be constantly changing as a different president comes into the Palace with different goals and views. The researchers resolved to use this span so the effect of changes of tax codes can be clearly seen. Tax Compliance of the self-employed Filipino taxpayer is measured by using the Personal Income Tax Effort ratio. This ratio can be computed by dividing the Actual Personal Income Tax Collected by the BIR over the Personal Income Tax Revenue Predicted by the Office of the President, DBCC, and the BIR.

14 Significance of the Study This study aims to examine the role of Philippine tax complexity with regards to personal income tax towards the tax compliance of self-employed Filipino taxpayers in the Philippines. Thus, this study will contribute to enhancing literature in this field and will try to provide an overview in respect to these issues. In addition, this paper will contribute to the tax literature for the information obtained on tax complexity and possible determinants of compliance will be added to the limited literature available in the region and may be used for future research to provide the basis to develop tax knowledge and personal income tax system complexity measures. From the policy makers’ perspectives, expected results obtained from this study may help them understand the important segments of complexity of the personal income tax system. Furthermore, the information gathered will assist tax authorities to develop their tax education and simplification program that will hopefully be a model or a guide to improve the level of tax compliance among taxpayers. The expected findings of this study could also be a model or a guide to many developing countries like the Philippines to improve the level of tax compliance amongst taxpayers. Scope and Delimitation This study will focus on the analysis of the role of the complexity of the Philippine tax system towards tax compliance in relation to personal income tax. Thus, it will be achieved by determining certain factors and segments that contribute to the complexity of the personal income tax system and evaluation of its effect to personal income tax filing of self-employed individuals in the Philippines. This study will be limited only to the area of personal income taxes and nothing more. This study will not be used to generalize the relationship of the complexity of the Philippine tax system as a whole to the tax compliance. It may also not be utilized for any other types of taxes. Research Hypotheses Null Hypothesis



The complexity of the personal income tax system of the Philippines does not affect the tax compliance of self-employed Filipino taxpayers.

15



The personal income taxation system of the Philippines does not require the extensive understanding of the taxpayer.

Alternative Hypothesis



The complexity of the personal income tax system of the Philippines negatively affects the tax compliance of its citizens.



The personal income taxation system of the Philippines requires the extensive understanding of the taxpayer.

Assumptions 

The complexity of the personal income tax system of the Philippines will have an effect on the tax compliance of the self-employed Filipino taxpayers.



An extensive understanding of the personal income tax system of the Philippines is not required to understand the Tax Code in relation to personal income tax.

Definition of Terms 

Tax complexity – a multidimensional concept that comes from tax laws and design



Tax compliance – is the degree to which a taxpayer complies with the tax rules of his country.



Tax avoidance – is the use of legal methods to modify an individual’s financial situation to lower the amount of income tax owed.



Tax evasion – is an illegal action wherein an individual person or entity avoids paying the tax liability



Taxable capacity - is the predicted tax revenue collection that can be estimated with the usage of regression analysis, taking into account the country’s specific macroeconomic, demographic, and institutional features.

16 

Tax effort ratio - is the index of the ratio between the tax revenue collection and the taxable capacity.



Legislation – the law, the Tax Code, in this study, specifically the personal income tax code Chapter 2. Review of Related Literature This chapter presents the related literature and studies found by the researchers after a thorough

and in-depth search. Tax System Complexity Tax system complexity, or simply tax complexity, is prevalent all over the world. It has become a concern to individuals, firms, and the country’s government (Hoppe, Schanz, Sturm, Sureth-Sloane, 2017). Evans and Tran-nam (2013) gave three definitions of tax complexity in three different perspectives. A tax accountant’s definition of tax complexity is the time it takes to file an income tax return or to give taxation advice and assistance to a client. To a tax lawyer, tax complexity would mean the difficulty of the tax code to be understood, read, and applied. A businessman sees tax complexity as the monetary costs needed to be paid to comply with the requirements of the law, along with the time to be spent in the process of complying. These differing views, according to Evans and Tran-Nam, make tax complexity a multidimensional and hard to measure concept. Hoppe et al. (2017) stated that most studies do not view tax complexity to be a multidimensional concept. They gave other studies that only show that there is only one driver of tax complexity, which is merely frequency of changes, or readability of the code, or details of the tax law. Ulph (2014) stated that According to Evans and Tran-Nam (2013) there are four aspects of complexity. These four aspects are predictability, enforceability, difficulty and manipulability. These aspects are description of the system. Another alternative, also stated by Evans and Tran-Nam, are to base these aspects on the stages of the operation of the tax system. These stages are the policy complexity, statutory complexity, administrative complexity, and compliance complexity. Firstly, policy complexity arises because of the policy choices by the policymaker. Next, statutory complexity is from the drafting of the tax laws, while administrative complexity is because of the tax administrators’ practices and rules (these two, according to Evans and

17 Tran-Nam can be considered as one aspect, which is legislative complexity). Lastly, compliance complexity is from the tax compliance behaviour and tax computation of the taxpayers. Saad (2014) indicated that tax complexity emerges because of the continuance of the increase of the sophistication of the tax law. Partlow (2013) stated possible causes for the complexity of the tax system. He stated that the cash basis accounting, prepayment of taxes, process of developing tax policies, realization concept, and the use of net income in determining tax liability may be reasons for tax complexity. The scope of the tax system, the progressivity, the abuse, and the systematic elimination of loopholes are some of the most noteworthy causes, as stated by Partlow (2013). The 2016 Global MNC Tax Complexity Survey which was conducted by the Ludwig Maximillian University of Munich, also determined causes of tax complexity. The respondents of the survey were 1,000 tax practitioners from 143 countries. According to the survey, the most important sources of tax complexity are ambiguity and interpretation. The subsequents sources, ranked according to importance, are change, record-keeping, detail, and computation. These regulations affected by these sources were then determined by the survey. All of these sources affected transfer pricing regulations the most. Other regulations affected by the sources are investment incentives, corporate reorganization codes, general anti-avoidance rules, dividends, royalties, controlled foreign corporations, interest & thin capitalization, and depreciation & amortization. Due to the multidimensionality and numerous sources of tax complexity, researchers, firms, and government agencies have developed different measurements of tax complexity. Both the studies of Ulph (2013) and Evans and Tran-Nam (2014) have stated various indicators of which aspects of tax complexity to measure. Evans and Tran-Nam (2014) has even provided proposals for indexes for future researchers. PriceWaterhouseCoopers (PWC), in partnership with the World Bank and the International Finance Corporation (IFC), developed ‘Paying Taxes’, now on its 13th year. ‘Paying Taxes’, measures the tax complexity of 190 countries by measuring the time it takes for the medium-sized corporation to comply with the tax requirements, the number of payments in each country, the post-filing index, and the total tax

18 and contribution rate. This measurement only measures the compliance complexity of the tax system, and not all the dimensions of tax complexity, as Evans and Tran-Nam (2014) stated. The United Kingdom has set up an independent agency called the Office of Tax Simplification, the first in the world to tackle specifically the issue of tax complexity and give suggestions to the government about ways to make the UK tax system simpler. The objective of the agency is to reduce the tax compliance burdens of the taxpayers. The Office of Tax Simplification (2017) has developed the OTS index, which measures the complexity of a tax system. The index was first developed in 2012, revised in 2013, and again in 2015. The index to be used in this study is the latest index with revisions released by the agency, which was in 2017. The OTS gave two uses for the index. The first one is that the index can be used to identify which parts of the tax system need simplification and prioritise them. The second use of the index is that it can be used by policymakers as a tool to analyze the effects of their tax reforms. This index divided tax complexity into two, the underlying complexity and the impact of complexity. The underlying capacity is used to measure the complexity of the structure of a tax system. The underlying complexity is simply what taxpayers have to go through to know what taxes they should be paying (with no prior knowledge) and to comply with their tax requirements. The underlying complexity is based on the policy complexity, legislative complexity, and the administrative/operational complexity. Policy complexity is the difficulty of the tax concepts to be understood. It has two measures: number of tax exemptions plus reliefs, and number of changes in the tax code since the base year. The number of tax exemptions plus reliefs is included because the increase of the number of these also increases the complexity of the tax system, because it adds more steps to the tax payment of the taxpayer. The Office of Tax Simplifications (2017) indicated that the more items that the taxpayer has to consider and sort through, the more complex a tax system is. The number of changes in the tax code is also a measure of complexity, specifically policy complexity, because it makes planning for the future really burdensome for the taxpayers. Change makes it difficult to know the possible effects of a future transaction.

19 Legislative complexity is how difficult the legislation can be understood. The two measures for this indicator are the Gunning-Fog Readability Index, and the number of pages of the legislation. The Gunning-Fog Readability Index is a comparative indication on how legislation can be easily read. Most readability measurements also have similar formulas to it, according to the Office of Tax Simplifications (2017). The length of the legislation is used by the index as an indication of how simple or complex the tax system. According to the index, the longer the legislation, the simpler the tax system. This is because a longer tax code would mean there is more detail, therefore less ambiguity and confusion. Operational complexity is the measure on how difficult it would be for the taxpayer to comply with the requirements. There are two measures for operational complexity which are complexity of the BIR guidance, and complexity of information requirement to make a return. Since taxpayers usually will not look in the actual tax code, but only on the guidance of the tax collection agency, the complexity of their guidance will be measured also. Complexity of information requirement to make a return is the difficulty for the taxpayer to gather all the requirements to meet the tax obligation. The impact of complexity is the other half of the tax complexity measurement. It is the measure of the costs of tax complexity to the taxpayers and to the tax collection agency. According to the Office of Tax Simplifications (2017), these factors will be the ones to produce much benefit to the taxpayers. Impact of tax complexity has four measures. The first one is the number of taxpayers, because the number of taxpayers and the impact of tax complexity have a direct relationship. The second one is the net average cost to taxpayers and the tax collection agency. This is the total cost to both the taxpayers and the tax collection agency to fulfill their respective responsibilities. The third measure is the average ability of the taxpayers. This is included because the lower the ability of the taxpayer to pay, the larger is the impact of the tax requirement. The last measure for impact of tax complexity is the avoidance risk. This is the amount of tax at risk for avoidance. The OTS Index will also use a standardized formula to measure the ten indicators. This formula will scale the indicators into a number between 0 and 1, for simplicity. The formula is Y1=(Y-Ymin)/(Ymax-Ymin).

20 The Personal Income Tax System of the Philippines The Philippine Personal Income Tax system has recently undergone a major tax reform. The effectivity of the new reform, namely the Tax Reform for Acceleration and Inclusion (TRAIN) Act, officially cited as Republic Act No. 10963, was on January 1, 2018. This paper will cover the significant changes affecting personal individual tax, pre-TRAIN period and post-TRAIN period. Before the implementation of the TRAIN law, the income tax rates ranged from 5% - 32%. If a person’s income ranges from Php 0 – 10,000, their tax rate would be 5%. A person with an income ranging from Php 10,000 – 30,000, the tax rate for them would be 10% plus Php 500. With an income ranging from Php 30,000 – 70,000, a person’s tax rate would be 15% and Php 2,500. A person’s income that ranges from Php 70,000 – 140,000 would be taxed at 20% plus Php 8,500. The tax rate of a person with an income ranging from Php 140,000 – 250,000 would be 25% and a payment of Php 22,500. An income ranging from Php 250,000 – 500,000 would be taxed at 30% plus payment of Php 50,000. The biggest income tax rate would be 32% plus Php 125,000 for people earning Php 500,000 and above. After TRAIN Law, the income tax rates ranged from 0% - 35%. After the TRAIN law implementation, more people were exempted from the income tax. People with incomes of Php 250,000 and below are exempt from the income tax. People with an income ranging more than Php 250,000 but not over Php 400, 000 will be charged with 20% on the excess over Php 250,000. An income Php 400,000 but not more than Php 800,000 will pay Php 30,000 and 25% of the excess over Php 400,000. A person’s income of more than Php 800,000 but not over Php 2,000,000 per year will be taxed with Php 130, 000 plus a 30% rate for the excess over Php 800,000. Individuals with over Php 2,000,000 - Php 8,000,000 annual income will pay Php 490,000 plus 32% of the excess over Php 2,000,000. The largest tax bracket for the income tax in the TRAIN law is for people with an income of more than Php 8,000,000. They are required to pay Php 2,410,000 and 35% of the excess over Php 8,000,000. The bonus threshold of the employees is also affected by TRAIN law. An increase in the threshold by Php 8,000 is imposed. Before TRAIN, the threshold for bonuses received by employees

21 amount to Php 82,000 but with TRAIN, it increased to Php 90,000. With this, the government is giving back as much as Php 137 billion to the people. The TRAIN law also reduces the compliance cost for self-employed and professionals, especially small taxpayers by giving them the option to avail of the 8% flat tax on gross revenues in lieu of income and percentage tax provided with the following requisites: 1. They must be individual earning from self-employment or practice of profession. 2. Their gross sales/receipts and other non-operating income did not exceed the Php 3,000,000 VAT threshold during the taxable year. 3. They must be registered and subject only to percentage tax under Section 116 of the NIRC, as amended; or taxpayers exempt from VAT or other percentage taxes; AND 4. They must signify their intention to elect the 8% income tax rate thru any of the enumerations under Section II(7) of this Order. The BIR clarifies that the following taxpayers cannot avail the option to be taxed at 8% of their gross revenues. 1. Purely Compensation Income Earners. 2. VAT-registered taxpayers, regardless of the amount of gross sales or receipts and other nonoperating income; 3. Taxpayers exempt from VAT or other percentage taxes whose gross sales/receipts and other nonoperating income exceeded the Php 3,000,000 VAT threshold during the taxable year; 4. Taxpayers who are subject to Other Percentage Taxes under Title V of the Tax Code, as amended, except those subject under Section 116 of the same Title; 5. Partners of a General Professional Partnership (GPP); 6. Individuals enjoying income tax exemption. Inclined also to the recent reforms amended in the TRAIN law, the basis and rate of the Optional Standard Deductions (OSD) are changed. The pre-TRAIN law tax system imposes a 10% optional

22 deduction rate based on the Gross Profit of the individual taxpayer. The post-TRAIN law tax system increased the rate to 40% but this is based on the Gross Sales/Revenue of the individual. Tax Compliance Saad (2014) defined tax compliance as the willingness of individuals to act in accordance with both the “spirit” and the “letter” of the tax law and administration without the application of enforcement activity. He also cited Roth et al. that defined tax compliance as filing all required tax returns at the proper time and that returns accurately report tax liability in accordance with the tax law applicable at the time the return is filed. Al-Maghrebi, Ahmad, and Palil (2016) stated that the Internal Revenue Service (IRS) in U.S.A. and Inland Revenue Board of Malaysia (IRBM) defined tax compliance as the degree of taxpayers’ willingness to comply with tax codes voluntarily and filing all required tax, along with the declaration of correct income and payment of all taxes, penalties and interest timely while claiming the true deductions and exemptions. Determinants of Tax Compliance Engida and Baisa (2014) classified four categories of factors based on an interdisciplinary perspective representing a wider perspective of tax compliance determinants compared to other researchers. The four categories are economic, institutional, social, and individual. And in addition, he included some demographic factors that may as well affect taxpayers’ tax compliance. Economic Factors are those actions associated with the costs and benefits of performing the actions. The assumption is that taxpayers are economic evaders who likely would assess the costs and/or benefits of evasion. Tax Audits for example can play an indispensable role is to increase voluntary compliance. Frequencies and meticulousness of audits can encourage taxpayers to a more prudent income tax return by reporting all income and claiming the correct deductions to come up with their tax liability. In contrast, taxpayers who have never been audited might be tempted to under report their actual income and claim false deductions. Another example is the taxpayers’ perception of Government Spending wherein taxpayers want to see the return of their money’s worth through government expenditures like education, health, and safety that will likely increase voluntary compliance

23 Institutional Factors is concerned with the efficiency of the tax authority or in other words, the government which influences the taxpayers through their effective operation of the tax system. Helhel and Ahmed (2014) added that effective tax policy and tax instruments or efforts of tax auditors are ways to attain voluntary tax compliance. In addition to this, the state’s economic and political structures and its degree of development are also factors that impact tax compliance. Social Factors are determinants that relates to the taxpayers’ willingness to comply with the tax system in response to other taxpayers’ tax compliance behavior and their environment. An example for this is the perception for equity and fairness which can be harnessed through the three-dimensional views, namely the horizontal, the vertical, and the exchange equity. Another example is changes in the taxing policy which can favor one segment and opposite for another. Individual Factors are personal circumstantial factors like personal financial constraints (financial distress that may encourage him to prioritize some things over another) and awareness of penalties and offences (the higher the penalty and the potential audit probability the greater the discouragement for potential tax evasion) that are likely to have a significant impact on taxpayer compliance behavior. Another big factor is the taxpayers’ tax knowledge because it is their understanding about taxation especially regarding the laws and regulations of taxation. Demographics and other variables like income, age, gender, education, etc. that can affect tax compliance in a mixed number of ways which are confirmed by numerous contradicting studies, meaning the results vary from different contexts. Saad (2014) identified 14 key variables of compliance behavior, namely age, gender, education, income level, income source, occupation, peer influence, ethics, fairness, complexity, tax authority contact, sanctions, probability of detection, and tax rates. While Helhel and Ahmed (2014) cited that there are two main behavioral models that affect taxpayers’ compliance, namely the internal which includes the thoughts and perceptions of taxpayers about taxation that shape one’s behaviors and attitudes, and the external which includes the tax system and technique, approach of tax administration to taxpayers, general sense of political evidence in public opinion, tax knowledge, and legal arrangements. Al-

24 Maghrebi et al. (2016) cited Devos who conducted a study that showed a significant relationship between tips and advices offered by tax professionals and the compliance behavior of individual taxpayers. Measurement of Tax Compliance and Non-Compliance Scholars have tried from past studies to use econometric techniques to measure and examine the performance of tax revenue, its potential and the extent to which the tax authorities would utilize this potential. This led them to the development of two key concepts in taxation studies: the tax capacity and tax effort. Taxable capacity is defined as the predicted tax revenue of a country which is estimated empirically taking into account its specific economic, demographic, and institutional features. The main factors that leads to the determination of the taxable capacity are: (a) Size of Population since the taxable capacity is very much affected by changes in national income and the rate of growth in population that affects the per capita income, (b) Distribution of National Income, (c) Character of Taxation which if taxes are devised wisely, then they give less resentment from people and will result to a large yield, (d) Purpose of Taxation has a direct bearing to the taxpayers because if the citizens are satisfied with the purpose of taxation, the more they are willing to comply, (e) Psychological Factors since this tackles the outlook of the taxpayers in terms of their support on their country and their patriotism, (f) Taxpayers Standard of Living, (g) Effect of Inflation in which if the country is experiencing inflation, purchasing power of people is reduced, thus shrinking taxable capacity. But if value of money is high and country is not faced with unemployment, then taxable capacity will be high. The tax effort ratio is an index of how effectively a country uses its available tax instruments in collecting taxes, relative to what the country could be reasonably expected to collect from these tax instruments. The formula for the tax effort ratio is: te = tr/tc, where te is the tax effort ratio, tr is the total actual tax revenue collection during the taxable year provided by the annual BIR reports as shown in their official website, and the tc is the projected tax revenue computed by the Database Consistency Checker as stated by the President in his State of the Nation Address.

25 The Database Consistency Checker (DBCC) through the Executive Order No. 232 was created on May 14, 1970 which was intended primarily to review and approve the macroeconomic targets, revenue projections, aggregate budge level, borrowing level, and expenditure priorities. The targets approved by the Office of the President are then recommended to the Cabinet, the President of the consolidated public sector financial position, and the national government fiscal program. Schumtz (2016) listed the common methods of measurement for tax non-compliance can be divided into two broad categories: the Macro or Top-Down Methods which are based on discrepancies between aggregated data, and the Micro or Bottom-Up Methods which use individual, business or household level data to identify tax non-compliance. Among the Micro Methods is the National Accounts and Other Macro Discrepancy Methods which compares GDP measures calculated with the income versus expenditure (or production) approach and requires that the GDP income approach be based on tax statistics, the data used must be different to that used in the expenditure (or production) approach and its calculation needs to be fully independent of the other two GDP calculation approaches. Another one included in the Micro Methods is Non-Reclaimed Withholding Tax which means undeclared assets can be estimated based on the assumption that withholding tax is mainly non-reclaimed for income from assets which have not been properly taxed. On the Other hand, an example of Micro Methods is Taxpayer Audits which involve careful auditing of a sample of taxpayers and extrapolating the results to estimate tax non-compliance for the entire population. Another example is Survey Methods where information on tax non-compliance can also be collected. Micro Discrepancy Methods which compares individual budget survey data with tax data, assuming the former includes true income figures, which is a rather controversial assumption is considered a micro method, as well as Traces of Non-Compliance in Consumption Behaviour which is based on consumption behaviour, assuming a close dependence between consumption and income, and other micro methods.

Tax Compliance in the Philippines

26 Paying Taxes, courtesy of PwC and the World Bank Group, investigates and compares tax regimes across 190 economies worldwide using a medium-sized domestic case study company. This works through a tax software with real time reporting systems and data analytics that showcases the way companies meet their tax compliance obligations and how tax authorities monitor and enforce those obligations. In its 13th edition, the Asia Pacific Region average for time of filing was 220 hours while the Philippines’ was 181 hours, a 39-hour advantage over the region average. While number of payments for the region was 15.9, for the Philippines it was 14, again an advantage over the region of 1.9. Average Total Tax & Contribution Rate for the Asia Pacific region was 32.8% while its 42.9% for the Philippines, a 10.1% disadvantage. While the newest addition to the Paying Taxes program which is the Post-Filing Index, which is used in the report to measure the efficiency of the processes that occur after the compliance of tax obligations, for the Asia Pacific Region was 62.4 while the Philippines garnered 50, a 12.4% advantage over the region. Overall, based on the given data, the performance with regards to tax compliance of the Philippines is advantageous over the Asia Pacific region. As written by Palabrica (2016), it is ideal for the rules of taxation to be written in a manner where the taxpayers can easily understand and comply with without the outside help or assistance so that it can facilitate voluntary compliance. But the tax laws in the Philippines are written in a way opposite of the ideals. He added that even professionals who are not experts of tax law are daunted by it. Multiple businessman-taxpayer seeks the service of an accountant or lawyer with sufficient expertise in taxation to assist him in the preparation of his tax returns just to avoid running afoul with the law or get a visit from BIR examiners. Also, some companies create a staff solely dedicated to all matters related to tax in an effort to make sure they are compliant with requirements. Even though the Government throws in bureaucratic obstacles to make the tax compliance process tedious and stressful, thanks to the patience of majority of Filipino taxpayers, they continue to pay their taxes despite the difficulties and disincentives of tax compliance.

Chapter 3. Research Method

27 Research Design The type of research to be utilized by the researchers is a correlational research design which will determine the relationship between the tax complexity of the system with regards to personal income tax and the tax compliance of the Filipino citizens. This type of research is a non-experimental research in which the researchers will measure the two variables, tax complexity and tax compliance, and identify their statistical relationship. The researchers have no extraneous control over the two variables. To measure the complexity of the personal income tax system, Office of Tax Simplification (OTS) Index will be used. To measure tax compliance of self-employed Filipino taxpayers, the personal income tax effort ratio will be used. The relationship between the two resulting variables will be used by the researchers to analyze the impact of personal income tax complexity to the tax compliance of self-employed taxpayers in the Philippines. Study Locale The data to be analyzed by the researchers will be gathered through the use of the existing Tax Code of the Philippines, through the tax revenues statistics provided by the BIR, and other government transparency publications in the Philippines. Data gathered by firms like PwC and the World Bank may also be used. Population and The Sample This study will only use secondary data. The instruments used in this study are Philippine government transparency publications and reports. The data to be used are made for the use of the public and only applied by the researchers to this study. No sampling technique will be necessary for this study because the researchers do not need to choose from a population. This research will not involve any surveys, interviews, test subjects, and the like. This research will be purely from secondary data gathered from government agency websites and annual comparative rankings by PwC and the World Bank.

The Instruments

28 The data to be gathered by the researchers are secondary data from government agency websites and transparency reports. The BIR website, http://bir.gov.ph, has most of the data needed by the researchers. The transparency annual reports of BIR range from 2008-2017, and they also have quarterly reports for 2018. Data needed from beyond 2008 is well-documented in the file ‘BIR Chronicles’. Important reforms are also included in the ‘BIR Chronicles.’ The legislations needed to be measured are also in the BIR website. The Philippine Statistics Authority (PSA) website, http://psa.gov.ph, also contains data, especially economic data, needed for this study. The annual PwC reports of ‘Paying Taxes’ and annual ‘Doing Business’ reports of the World Bank will also be utilized. Data Collection Procedure Quantitative information will be used to analyze the personal income tax system complexity and the tax compliance of self-employed individual taxpayers in the Philippines. The researchers will gather pieces of information from internet journals, from comparative rankings by the PwC and World Bank, from annual reports of tax revenue collections of the BIR, and from other data to be gathered from other government websites. The researchers will use the Office of Tax Simplification (OTS) Index to measure the tax complexity of the personal income tax system in the Philippines. The Tax Code of the Philippines and the revenue statistics of the BIR will be the subject for most of the measurements of the indicators in the OTS Index. Most of the data to be gathered by the researchers are from the year 2008 to the current year 2018. The researchers will use the PwC ‘Paying Taxes’ and World Bank ‘Doing Business’ reports for the operational complexity measurements. The researchers will also base on the Comprehensive Socioeconomic Survey by the PSA for the ability of the taxpayers to pay taxes. The results will be used to determine how complex the personal income tax system. To measure the tax compliance of self-employed Filipino taxpayers, data also gathered from the BIR statistics and annual reports will be utilized. After gathering the respective results of each variable, the researchers would analyze the data to identify the relationship of personal income tax complexity and tax compliance of self-employed Filipino taxpayers in the Philippines.

29 Statistical Treatment of Data The data gathered will be analyzed by the researchers using the Pearson’s r model. This model will identify the relationship between the personal income tax complexity and tax compliance of selfemployed Filipino taxpayers. The data will be shown by the researchers in a data chart where X represents tax complexity of the Philippine personal income tax system per year while Y represents tax compliance of self-employed Filipinos per year. The coefficient value resulting from the model will then be the basis of the researchers regarding the relationship of the two variables. The coefficient value should range between -1 and +1. A negative value shows indirect relationship between the variables while a positive value shows direct relationship. The formula used by the researchers is shown in Figure 3.

Figure 6. Pearson’s r model

Where: r = the coefficient value N = number of pairs of scores X = Tax complexity score per year Y = Tax compliance score Ethical Consideration The research conducted is a non-experimental quantitative research which does not involve any respondents and only rely only on available secondary data. The data that will be gathered by the researchers are absolute and free of manipulation. The researchers have to take caution in obtaining the data from the BIR and other government websites which are made available to the public. Precision and

30 accuracy in encoding these data are observed by the researchers for the credibility and effectiveness of this study. All data gathered by the researchers are properly cited using APA 6. Therefore, strict ethical considerations of research are followed by the researchers in this study.

References

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