Optimal tax compliance and penalties when the law is uncertain.

This article examines the optimal level of tax compliance and the optimal penalty for noncompliance in circumstances in which the substance of the tax law is uncertain--that is, when the precise application of the Internal Revenue Code to a particular situation is not clear. In such situations, a number of interesting questions arise. This article will consider two of them. First, as a normative matter, how certain should taxpayers be before they rely on a particular interpretation of a substantively uncertain tax rule? If a particular position is not clearly prohibited but neither is it clearly allowed, what is the appropriate threshold of confidence that the taxpayer ought to have before engaging in the transaction? Second, what penalty regime would give the taxpayer the right incentive with respect to relying on substantively uncertain tax law?

With these questions in mind, this article shows that, applying standard assumptions from the economic literature on deterrence, the tax penalty regime that would induce the optimal reliance (or non-reliance) on uncertain tax laws depending on the circumstances would involve (1) a rule of strict liability with respect to taxes owed as well as to the penalty and (2) a penalty that roughly approximates the famous Bentham-Becker punitive fine, calculated by dividing the harm (the underpaid tax) by the ex ante probability that the harm would be detected. This article also explains why a fault-based approach to tax penalties, under the standard assumptions of the classical deterrence model, would not work as well as the strict liability approach. Reasons for the inferiority of the fault-based approach include its comparatively high administrative costs, its inability to properly regulate "activity levels," and its relatively unattractive distributional consequences. This article concludes, however, that if Bentham-Becker level penalties or wide-spread use of tax liability insurance are not feasible, a second-best case can be made for using a fault-based penalty regime similar to the one currently in force. The framework used in this article may have implications for any area of law where the substantive law is uncertain.

I. INTRODUCTION

This article examines the optimal level of tax compliance and the optimal penalty for noncompliance in circumstances in which the tax law is substantively uncertain--that is, when the precise application of the Internal Revenue Code (Code) to a particular situation is not clear. These circumstances arise more often than one might think. There are many clear-cut cases in tax. For example, when tax protestors say that the U.S. tax laws do not require them to pay any tax on their U.S. income, they are wrong; and if they take such a position on their returns or, on the basis of this position, opt not to file returns at all, they will, if caught, face a substantial fine or even spend some time in jail. On the other hand, there are many close cases in tax.

Say you take a trip to Miami, during which you attend a job-related conference for one day and lounge on the beach sipping margaritas for two. Is the trip "primarily for business purposes" or not? Good question. (1) Or say you are a taxpayer engaging in a transaction primarily for the purpose of reducing your income tax liability and the transaction entails some, but very little, economic substance. Will a court respect the form of the transaction and allow the tax treatment you have chosen? Another good question. (2) These sorts of questions pervade the tax law, producing interesting issues for tax lawyers as well as good test questions for the basic income tax class in law school. This article addresses this sort of legal uncertainty.

A number of interesting questions arise in these ambiguous situations. I will focus on two of them. First, as a normative matter, what degree of substantive legal certainty should taxpayers insist on before they rely on a particular interpretation of a tax rule? That is, if a given transaction is not clearly prohibited, but neither is it clearly allowed, what is the appropriate threshold of confidence that taxpayers ought to have before engaging in the transaction? Take the mixed business/personal Miami trip mentioned above. How sure should you be about the deductibility of those expenses before taking such a position on your return? Or how much economic substance must a transaction have--how likely must a pre-tax profit be--to justify actually going forward? If we can answer those questions, the next question follows: what penalty regime would give taxpayers the right incentive with respect to relying on substantively uncertain tax law?

To address these and related questions, I will use the following hypothetical: Joe Taxpayer (who can be thought of either as an individual investor, a business owner, or a manager of a corporation) is trying to decide whether to invest, or have his company invest, in a particular business transaction. In making this decision, Joe takes into account a range of issues, all of which boil down to one obvious question: how much money will the transaction make net of costs? As part of this analysis, Joe considers the legal consequences of the investment, including the likelihood that the investment might lead to some sort of civil litigation or government enforcement action. Joe evaluates these legal risks then weighs them against the expected benefits of the deal. Among the legal risks he contemplates are the possible tax consequences of the transaction.

Now, focusing the analysis on the tax planning question, assume that from Joe's perspective (or that of his company) the investment is worth making only if it qualifies for a particular tax treatment. That is, assume the deal makes sense--its overall expected benefits exceed the overall expected costs--only if it qualifies as a "nontaxable transaction" or, alternatively, only if it generates a special tax loss or tax credit that can be used to offset taxes on other income. Thus, the after-tax profitability of the deal turns on the answer to the tax question. Now here is the problem: If Joe's expert tax advisor tells him that the special tax treatment he seeks for the transaction is neither clearly forbidden nor clearly legal under the existing tax laws, how should Joe proceed? In other words, if the law in question, at least as applied to Joe's particular transaction, is uncertain (in terms of how it will be applied ex post by the Internal Revenue Service (Service) or courts to particular transactions), what incentive does society want Joe to have in this situation? What is the optimal degree of tax compliance and what is the optimal tax penalty regime?

As it turns out, the answers to these questions depend on a number of factors. To see this point, let us simplify the analysis further by assuming that the only thing Joe cares about with respect to tax planning is the expected value of the sum of the possible back-taxes (plus interest) and the potential penalty. Joe, in other words, is a rational actor in the traditional economic sense of the term, a true homo economicus; more pejoratively, Joe is a quintessential example of Holmes's "bad man." (3) Assume further that not only is Joe without a conscience but he faces no informal external sanctions either, such as social norms against tax noncompliance. Either his friends, neighbors, co-workers, and fellow corporate managers are utterly indifferent to Joe's reputation for paying his taxes, or he is indifferent to their opinions.

Given all of these simplifying assumptions, Joe's decision regarding whether to undertake the particular transaction in question, and whether to report the transaction on his tax return in the desired manner, will depend on his ex ante assessment of (1) the probability that the particular tax position in question will be discovered and scrutinized by the Service, (2) the probability that, if detected, the position would be rejected by the Service and ultimately by a court, and (3) the size of the penalty in the event of both detection and rejection. (4) Obviously Joe would not be able to estimate these variables with great precision, but presumably he would give it his best shot or pay a tax advisor to do so. It also seems sensible to assume that Joe would invest in additional information, up to the point at which the marginal cost of the additional information equals the marginal benefit gained from the information. Again, assuming there is some residual uncertainty even after these investments in information are made, then the question of whether the deal is profitable to Joe will depend on this evaluation of uncertain tax law and uncertain tax law enforcement.