Homo oeconomicus XV (1) (ACCEDO Verlagsgesellschaft, München 1998) Tax Compliance Policy Reconsidered by Bruno S. Frey and Manfred J. Holler * Abstract: Strong empirical evidence suggests that, contrary to standard criminal choice theory, deterrence does not increase tax compliance. A model based on a peculiarity of the mixed-strategy Nash equilibrium in 2-by-2 games is used to explain this observa- tion theoretically: The strategy choice of a player is not affected by the changes in his or her payoffs induced by deterrence. Moreover, as empirical observations show that increased deterrence tends to undermine tax morale under relevant conditions, it fol- lows that tax policy should not so much try to deter but should make an effort to main- tain and raise citizens' tax morale. 1. Introduction Empirical evidence strongly suggests that higher penalty rates do not decrease tax evasion. "Most studies have failed to demonstrate that higher penalty rate encourage compliance" (Roth, Scholz, and Witte, 1989, p. 6). The size of the deterrence effect (in the few cases where it has been found statistically significant) is very small, and less consequential than the impact of other factors (see, e.g., Paternoster, 1989). Calcula- tion based on empirical magnitudes for the United States show that "taxpayers would have to exhibit risk aversion far in excess of anything ever observed for compliance predicted by expected utility theory to approximate actual compliance" (Alm, McKee and Beck, 1990, p. 24). As a reaction to similar calculations for different periods, other authors go so far as to state "that most of the theoretical work to date is not particularly useful either for policy analysis or empirical study" (Graetz and Wilde, 1985, p. 357). * Institute for Empirical Economic Research, University of Zürich, Bluemlisalpstrasse 10, CH-8006, Zürich, and Institute of Economics, University of Hamburg, Von-Melle-Park 5, D-20146 Hamburg, respectively. The authors are grateful to Rainer Eichenberger and Laszlo Goerke for helpful suggestions. An earlier version of this paper has been published as "Moral and Immoral Views on Paying taxes"(1997) in: S. Hellsten, M. Kopperi and O. Luokola (eds.), Taking the Liberal Challenge Seriously. Essays on Contemporary Liberalism at the Turn of the 21st Century, Aldershot et al.: Ashgate.