Why People Pay Taxes: Third-Party Reporting

Why tax compliance is high when employers or banks report income to the government, and how India uses TDS and data to widen its tax net.

Why do people pay taxes? Fear of penalties plays a role, but a big factor is simply whether the government knows about their income.

The Denmark study

In a study published in 2011, economists Henrik Kleven and colleagues ran a large experiment with Danish tax authorities. They found:

For income reported by third parties, such as wages reported by employers, evasion was almost zero.
For self-reported income, such as some business income, evasion was much higher.

The key to compliance was information, not tax morale alone.

Third-party reporting

When employers, banks or buyers report payments to tax authorities, evading tax becomes very hard. This is why:

Salaried workers have high compliance.
Self-employed people and small businesses have more opportunity to evade.

India’s approach

TDS (tax deducted at source): employers, banks and businesses deduct tax and report payments.
Annual Information Statement: gathers data on salaries, interest, dividends, property purchases and large transactions.
GST invoices create paper trails through supply chains.
PAN and Aadhaar linking.

These tools expanded India’s tax base.

Why developing countries collect less tax

Economists Timothy Besley and Torsten Persson note that poorer countries collect less tax partly because large informal sectors lack third-party reporting.

Formalisation

As more transactions go through banks and digital payments, third-party reporting grows, which can raise compliance and revenue.

The salaried and the shopkeeper

A salaried employee's income is reported by her employer, so her tax is deducted automatically. A shopkeeper selling in cash has income the government can't easily see. As he moves to digital payments and GST invoices, his income becomes more visible.

Thinking tax evasion depends mainly on honesty

Evasion is much lower when third parties report income to authorities.

Key takeaways

A Danish study found near-zero evasion for third-party-reported income.
Self-reported income has much higher evasion.
India uses TDS, AIS, GST invoices and PAN-Aadhaar links.
Formalisation and digital payments widen the tax net.