Tax audits can significantly boost compliance, but only if designed well

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Businesses in Rwanda whose tax affairs were audited paid on average an additional $17,246 in taxes over the three years following the audit, a recent study shows.

The figure represents 5.9% of all corporate income taxes collected during that time.

In Rwanda, the government needs to spend 18.7% more of its GDP every year to meet the Sustainable Development Goals by 2030 in health, education, water and sanitation, roads and electricity.

If businesses underreport their income, it leads to less funding for such essential services so designing effective tax audits is vital.

The research, published in the Journal of Development Economics, saw the Tax Administration Research Centre at the University of Exeter Business School team up with the Rwanda Revenue Authority to evaluate the latter's business tax audits.

Crucially, the researchers found that the type of audit made a significant difference to tax compliance.

Comprehensive audits, consisting of face-to-face reviews of a business's financial records, had a strong positive effect on tax compliance, encouraging businesses to report their income more accurately for several years afterwards.

In contrast, narrow-scope audits, which are quicker, less detailed and often done through correspondence, produced mixed results. Tax reporting improved only in the first year and then reverted back, leading to an overall net negative impact.

The findings suggest that comprehensive and narrow-scope audits are not perfectly substitutable tools for improving compliance.

Professor Christos Kotsogiannis, from the Tax Administration Research Centre (TARC) at the University of Exeter Business School, said, "By focusing on the right kind of audits, Rwanda could make its tax system fairer and more efficient, helping fund the critical services the country needs and make progress towards meeting the Development Sustainable Goals.

"Although narrow-scope audits may seem cheaper and faster, they don't improve tax compliance as effectively and could even hurt efforts to collect taxes in the long run. Therefore, how these instruments are designed should be reconsidered. Investing in comprehensive audits may cost more upfront but offers a better return on investment by increasing future tax revenues."

The findings align with research from the United States that finds correspondence audits to be much less consistent in improving taxpayer reporting than detailed, face-to-face audits.

Drawing on the wider implications of the research, Professor Kotsogiannis added, "Improving tax enforcement is undoubtedly a major challenge for Revenue Authorities across the world particularly in developing countries where the need for tax revenues—the only form of sustainable public finance—is significant.

"What this research points to, in general terms and from a policy perspective, is that Revenue Authorities should pay close attention to the evaluation of their tax audits portfolio. We are delighted to have cooperated in this project with the Rwanda Revenue Authority, and that our research has such an impact in the way the tax audits are now designed."

More information: Christos Kotsogiannis et al, Do tax audits have a dynamic impact? Evidence from corporate income tax administrative data, Journal of Development Economics (2024). DOI: 10.1016/j.jdeveco.2024.103292

Provided by University of Exeter