A. Standard Deterrence Theory: The Rational Actor Model
Standard deterrence theory, as applied to tax compliance, assumes that taxpayers are rational actors seeking to maximize their expected utility. Accordingly, a taxpayer who is deciding whether to comply with the tax law will weigh the expected cost of tax evasion against the cost of complying and choose the cheaper option. The cost of complying is simply the amount of tax owed. The cost of evasion, however, is somewhat more complex. If a taxpayer evades and is caught, she will have to pay the tax owed and will also have to pay a penalty, which is usually some fraction of the tax owed (e.g., twenty percent). Together, this penalty added to the tax owed can be thought of as the total fine for evasion (F). There is a chance, however, that the IRS will not detect the taxpayer’s evasion, in which case the taxpayer incurs no cost. Thus, the expected cost of tax evasion is the total fine for evasion discounted by the probability of detection (P):
Cost of Compliance = Tax Owed
Expected Cost of Evasion = P x F19
For example, if the probability of detection were one percent (which is the current overall audit rate) and the penalty for evasion were twenty percent of the tax due, the expected cost of evading $100 of tax would be the $100 of tax due plus a $20 penalty (F = $120), discounted by one percent chance of being detected (P). The resulting $1.20 expected cost would be substantially cheaper than the cost of complying (i.e., the $100 of tax owed). In that case, a rational taxpayer would cheat.
A policymaker seeking to deter a rational taxpayer from evading tax can do so by raising the expected cost of evasion, with the goal of making it more expensive than the cost of compliance. It follows from the model that raising either the probability of detection or the penalty for evasion, or some combination of the two, can increase the expected cost of evasion. In the context of tax compliance, this means higher tax penalties, raising the audit rate, or finding some other method to increase the rate of detection.
At first glance, raising tax penalties appears to be a simple and potentially cost-effective solution for increasing tax compliance. Current civil tax penalties in the United States range from just twenty percent to seventy-five percent of the tax due, resulting in sub-optimal expected penalties if the risk of detection is small. n22 If Congress increased nominal penalties significantly, it could potentially deter tax evasion without investing more re-sources in ferreting out noncompliant taxpayers.
n22 In the example in the text above, the expected penalty for evading $100 of tax was just $1.20 when the risk of detection was one percent and the penalty was twenty percent.
Raising tax penalties, however, presents a number of hurdles. First, at a one percent rate of detection, optimal penalties would have to be set at more than ninety-nine times the tax evaded. n23 Such a departure from the current status quo is likely to be politically infeasible. Moreover, costs associated with significantly increasing nominal penalties counsel against such an approach. Extremely high tax penalties would likely be perceived as unfair in the case of inadvertent errors, and may be perceived as disproportionate even in the case of intentional evasion. In fact, harsh penalties may actually result in lower tax compliance if they foster resentment in taxpayers and “crowd out” their intrinsic motivations to comply. Higher tax penalties may also impose greater administrative costs, as there may be more procedural hurdles before the IRS could assert them, more resources expended by the government in prosecuting them, and more costs incurred by tax-payers in contesting them. Finally, at a certain level, high penalties will become uncollectible to the extent that they exceed taxpayers’ resources.
n23 See Leandra Lederman, The Interplay Between Norms and Enforcement, 64 OHIO ST. L.J. 1453, 1468 n.77 (2003). To see why this is so, consider again the taxpayer who is considering evading $100 of tax. For the expected cost of evasion to outweigh the cost of compliance ($100), the nominal penalty would have to be more than $9900 ([$9900 + $100 (tax owed)] x 0.01 (chance of detection) = $100).
Most versions of the rational actor model assume some level of risk aversion, which places an effective ceiling on penalties. See Daniel Shaviro, Disclosure and Civil Penalty Rules in the U.S. Legal Response to Corporate Tax Shelters, in TAX AND CORPORATE GOVERNANCE 229, 239 (Wolfgang Schon ed., 2008). For example, although a risk-neutral taxpayer would need to incur a $9900 penalty to be deterred from evading $100 of tax with a one percent chance of detection, a risk-averse taxpayer might be sufficiently deterred at a lower penalty. Taxpayers, however, are generally not thought to be so risk-averse that they would be deterred by current penalty levels (0.2 to 0.75 of the tax) at a risk of detection of only one percent. See, e.g., Terrance Chorvat, Trust in Taxation, in BEHAVIORAL PUBLIC FINANCE 210 (McCaffery & Slemrod eds., 2006); Sanjit Dhami & Ali l-Nowaihi, Why Do People Pay Taxes? Prospect Theory Versus Expected Utility Theory, 64 J. ECON. BEHAV. & ORG. 171, 172 (2007).
Given the obstacles to raising tax penalties, the government might instead focus on increasing the probability of detection, which could be achieved by increasing the audit rate or the thoroughness of current audits. But such a strategy would likely face public resentment and political hurdles, as evidenced by the backlash against prior efforts by the IRS to boost its auditing program. Additionally, many view the IRS’s resources as too constrained to expand audits significantly.
Another method by which the government has increased the rate of de-tection is through third-party information reporting. The IRS collects information about taxpayers from third parties such as employers and financial institutions, compiles the data in an internal database, and then electronically matches the data with information that the taxpayers report on their tax returns. If the IRS finds a discrepancy in the income reported by the tax-payer, the taxpayer may be flagged for audit. The vast majority of income that is reported to the IRS by third parties is also reported accurately by tax-payers on their tax returns (approximately ninety-two percent), which is consistent with standard deterrence theory. Because the rate of detection for evading taxes on such income is extremely high, the expected cost of evading taxes on that income is also high. Accordingly, if more types of income could be subject to third-party information reporting, compliance could be improved. The bulk of underreported income, however, arises out of transactions for which there are no viable third-parties to report to the IRS, such as a cash sale between a retailer and a consumer. For these types of transactions, which make up a substantial portion of the tax gap, the IRS must find an alternative means to promote better compliance.Of course, as presented, this is just the model for the economically rational actor. The author's point is that various other factors go into the mix of reporting taxes. She argues that those other factors must be evaluated and, shall we say, exploited in order to encourage more tax compliance.
There is untold wealth in America—especially at income tax time.Of course, for taxpayers exploiting the bullshit tax shelters, the current civil penalty regime -- 20%, 40% and 75% -- would not alone deter at least some of them (probably most). Most of the taxpayers who "invested" in the bullshit tax shelters (those sheltering millions in gains) sought penalty insurance from not only the bullshit opinions issued with respect to the bullshit tax shelters, but also from their independently engaged counsel who gave them whatever they felt they needed, for when they emerged from the consultation(s) with their independently engaged counsel, they "invested" in the bullshit tax shelters because of or despite such independent advice. I suppose that these taxpayers were somewhat comforted by their independent counsel's advice as to their own potential criminal exposure (even though their lies as to profit motive were an essential ingredient of the exercise). But looking solely to the civil dollar costs and risks, which is the subject of the rational actor deterrence model above, they apparently were willing to accept the risk. I suppose they could think that the civil fraud penalty (75%) might not be that great a risk, but it is not at all clear to me how their independent counsel could have possibly gave them any comfort on the accuracy related penalty of 20% and 40%. So we have a pretty stark and recent illustration on the ineffectiveness of the current penalty regime given -- (i) the current penalty costs of 20%, 40% and 75%, respectively, and (ii) the IRS's audit coverage (we know that many investors in these bullshit tax shelters were protected by what the IRS then perceived as the statute of limitations; although this may be in some doubt if the Government succeeds on its Allen position that § 6501(c)(1) imposed an unlimited statute of limitations for fraudulent positions of nontaxpayers).