The Case For Two Track Tax Enforcement

Alex Raskolnikov, a tax professor, has an exceedingly clever idea for improving compliance with tax laws described in a pre-print draft article.

His idea: Give taxpayers two choices regarding how questions about their returns will be handled that give them an incentive to choose the regime most likely to cause them to comply.

One regime, which would apply by default, would be similar to the current regime, but with civil penalties five times as high.

The other regime, with penalties the same as those under current law, which could be elected by return filing taxpayers, would included features such as:

1. The IRS is right unless clearly wrong in interpreting tax laws and facts
2. Binding arbitration with the IRS
3. Waiver of tax preparer privileges
4. Voluntary waiver of foreign law privacy protections
5. Higher standards for tax preparers (re disclosing aggressive positions)
6. Higher penalties for tax preparers
7. Reimbursement of costs for prevailing taxpayers
8. Separate enforcement staffs (elective taxpayer staff would be nicer)

The notion is that existing civil penalties are too weak to deter people who try to game the current system, but that stiff penalties are harsh for people who fail to comply despite not trying to game the system, and that high penalties discourage cooperation with tax authorities by people who aren't trying to take aggresive positions on purpose.

The elective regime would impose make it much more likely for taxpayers and their advisors intentionally relying on aggressive interpretations of tax laws to lose upon an audit, while imposing minimal costs upon taxpayers who simply made mistakes in applying sometimes unclear tax laws. Thus, the election would be designed to give taxpayers most responsive to high penalties an incentive to choose the traditional regime with high penalties, and would give taxpayers more responsive to a less adversarial approach an incentive to choose the elective regime.

Also, taxpayers found to have gamed the system in an audit under the elective approach could be barred from using it in future years.

He argues for some complex reasons, that the best strategy to accompanying this change would be to make decisions to audit at all without considering whether or not a taxpayer has made the election.

Also, the approach avoids constitutional challenge because taxpayers are free to elect the traditional regime that preserves all traditional legal rights, and will not be penalized for doing so unless they are found upon an audit to have failed to comply with the tax laws. Nothing in the constitution imposes limits on how high civil penalties for tax law violations may be, so long as they are reasonably proportional to the violation (the vast majority of tax penalties are a multiple or percentage of the amount of tax not paid).

The proposal isn't a comprehensive approach to closing the tax gap, nor is it intended to be.

But, one of the issues the proposal does not address, non-reporting of domestic income, is well suited to an entirely different solution: expanded information reporting. Another approach within the plan would be to apply greatly increased penalties under both regimes in the narrow area of intentionally not reporting gross income not subject to information reporting.

Others unaddressed issues, like non-reporting of foreign income, may not have any good solutions through a taxpayer level audit process. One recent breakthrough on that front was to audit credit card companies that facilitated access to non-reported foreign funds. Another may be tough multi-national diplomatic action against tax havens. A third approach could involve aggressive federal criminal enforcement directed towards taxpayers who fail to report tax haven income, a strategy that may have benefits in curbing money laundering and bankruptcy fraud as well.