Effect of behavioral biases on tax compliance among small and medium-sized enterprises owners Nairobi county, Kenya

Abstract

This study investigated the influence of behavioural biases on tax compliance among medium-sized enterprise (SME) owners in Nairobi County, Kenya. It focused on key biases, including mental accounting, risk aversion, authority trust bias, and overconfidence bias, to understand their impact on tax compliance behaviours. Despite efforts to streamline tax systems and promote voluntary compliance, challenges persisted, particularly in developing economies like Kenya, where the tax-to-GDP ratio had declined, signalling ongoing compliance issues. This study filled a critical gap in the literature, as previous research had largely overlooked the specific effects of these biases on tax compliance, particularly among SME owners in Nairobi County. The research applied theories such as Mental Accounting Theory, Prospect Theory, Institutional Trust Theory, and Behavioural Finance Theory to provide a comprehensive framework for understanding these biases. The target population consisted of 32,251 SME owners in Nairobi County who had registered and paid their trade licenses by July 2023. The study found that mental accounting did not significantly affect tax compliance. Despite the hypothesis that individuals who categorized their finances might show different compliance behaviours, the results revealed that mental accounting did not meaningfully influence tax compliance. In contrast, risk aversion showed a positive and significant relationship with tax compliance. SME owners who were more risk-averse demonstrated higher levels of compliance, likely due to a greater fear of penalties and legal repercussions. Authority trust bias, however, had a negative impact on tax compliance. SME owners who exhibited higher trust in authorities were less likely to comply with tax obligations, possibly due to a belief that authorities would overlook minor infractions. Lastly, overconfidence bias had a positive and significant effect on tax compliance. SME owners who felt more confident in their understanding of tax requirements and their ability to comply were more likely to fulfil their tax obligations. The findings provided valuable insights for policy interventions aimed at improving tax compliance rates among SMEs. By addressing both the structural challenges of tax systems and the cognitive biases influencing compliance behaviour, this study contributed to a better understanding of the psychological factors driving financial decisions. The research offered practical recommendations for tax authorities, policymakers, and SME owners, with the goal of supporting sustainable economic development through improved revenue collection and compliance practices.