Administrative Decentralization and Tax Compliance: A Transactional Cost Perspective

A common phenomenon in tax administration in developing countries is that tax is collected not according to the rules of law but according to informal agreements between taxpayers and tax collectors. This article offers a novel explanation of this phenomenon in the Chinese context in terms of administrative decentralization. Administrative decentralization is defined as the concentration of government functions at the lowest ranks of a geographically-dispersed bureaucracy. Decentralization increases communication costs associated with the implementation of law, and changes the structure of taxpayers’ costs in obtaining knowledge about the law. As a result, a “semi-compliant” type of behavior, involving many taxpayers who would have been compliant under a rule-based system, emerges where tax is remitted and collected despite both sides being under-informed about the law. The article argues that this dynamic has frustrated tax administration reform in China and, interestingly, explains the underdevelopment of the tax legal profession and of tax litigation.