Voluntary tax compliance and the mechanisms to catch the noncompliant are under stress as tax laws have become more complicated and IRS resources have not kept pace. These events in combination have created a genuine crisis in tax administration. The papers in this volume, prepared by economists, lawyers, and accountants, evaluate the capacity of authorities to enforce the tax laws in a modern, global economy and examine the implications of failing to do so. The conference, on which this publication is based, was jointly sponsored by the Brookings Institution, the Office of Tax Policy Research at the University of Michigan Business School, and the American Tax Policy Institute (under a grant from the American Bar Association).
The Crisis in Tax Administration
Brookings Institution Press
Copyright © 2004
Brookings Institution Press
All right reserved.
ISBN: 0-8157-0122-5
Chapter One
HENRY J. AARON
JOEL SLEMROD
Introduction
Tell someone you would like to discuss tax administration, and you are
likely to see their eyes cross with anticipated boredom. Ask that same person
what it was like to fill out last year's tax return or to respond to the last communication
with the Internal Revenue Service, and you are likely to see fists
clench and sense blood pressure rising. Tax administration is at once the dullest
of topics and a government function that arouses powerful emotions.
The paradoxes do not end here. Complaining that taxes are too high and that
the IRS is too intrusive is almost an American tradition. Yet most people pay
their taxes. They do so for two reasons, despite the cost and complexity of complying
with the tax law. On the positive side, many recognize, even if grudgingly,
that paying taxes is a duty of citizenship rather than the outcome of a cost-benefit
calculation. On the negative side, taxpayers know that the law requires
payment, that evasion is a crime, and that willful failure to pay taxes is punishable
by fines or imprisonment, even if the chances of being caught are remote.
The practical questions for tax administration are how much to spend on enforcement
to maintain the second of these motives for payment and how to
organize administration to get the best results for each dollar spent. But the
admittedly grudging willingness of many taxpayers to obey the law is critical to
the operation of the income tax system. If most people stopped dutifully complying
with the law, no feasible system of tax enforcement, short of police-state
tactics, would suffice to maintain current levels of compliance.
Lately Congress has restricted spending on tax administration, forcing the
Internal Revenue Service to curtail its enforcement activities. Between 1992 and
2001, when the number of individual returns increased from 114.7 million to
129.4 million and tax returns became increasingly complex because of new legal
provisions, the proliferation of sophisticated new financial instruments, and the
rapid increase of multinational business operations, the full-time-equivalent IRS
work force fell from 115,205 to 95,511, and the number of field compliance
personnel dropped from 29,730 to 21,421. As a result, enforcement coverage
steadily declined. For example, in-person examination of individuals fell from
5.8 per thousand returns in 1992 to 1.5 per thousand in 2001; correspondence
examinations fell from 4.0 to 1.2 per thousand returns. After lengthy congressional
hearings, during which numerous witnesses alleged various forms of
administrative abuse by the Internal Revenue Service (few of which were subsequently
confirmed), Congress forced extensive reorganization on the nation's tax
collection agency.
Tax legislation, globalization, financial innovation, and budgetary parsimony
have combined to create something approximating a crisis in tax administration.
Outgoing IRS Commissioner Charles O. Rossotti used exactly that
word in his end-of-term report to the IRS Oversight Board, asserting that the
"health of the federal tax administration system is on a serious long-term
downtrend." If the likelihood that evasion will be detected and punished falls
too low, those induced by fear to comply will no longer do so. And, as evasion
spreads, people who comply out of a sense of civic duty will come to feel like
dupes and be tempted to flout the law. To examine this threat, the Brookings
Institution in collaboration with the Office of Tax Policy Research at the University
of Michigan commissioned ten original studies on tax administration.
The papers were presented at a two-day conference sponsored by the Internal
Revenue Service, in collaboration with the American Tax Policy Institute and
with the support of the American Bar Association Section of Taxation. Each
paper was reviewed by two discussants. Edited versions of the papers, gathered
in this volume, examine various theories of tax administration, actual administrative
practices (including recent modifications initiated in response to legislation),
proposed modifications in that practice, and design of tax laws to
facilitate compliance and enforcement. The authors and discussants include
lawyers, economists, accountants, and officials from governments and international
organizations.
The studies show clearly that tax administration has emerged from academic
obscurity. Once a drab subject that held little interest for most serious scholars,
tax administration has become a front-burner issue. The simple fact is that good
theoretical concepts can easily founder on rocky administrative problems. The
Senate hearings that led to reorganization of the Internal Revenue Service further
fueled interest. In addition various proposals for fundamental tax reform
raise profound issues for tax administration. In the case of tax policy, "good in
theory, but bad in practice" means bad in theory, after all.
Tax shelters for corporations and wealthy individuals have recently become
front-page news. Whether use of abusive tax shelters is increasing and, if so,
what to do about it is indeed one of the most pressing issues in current tax administration
policy. In practice, shelters are created by accountants and lawyers
and are marketed aggressively. Current enforcement practice revolves around
the "economic substance" doctrine, which allows the IRS to disregard transactions
that lack nontax motivation or effect. But, as Joseph Bankman points out
in chapter 2, there is no clear statement on how much economic substance is
enough. A major goal of tax shelter authors is to invest the transaction with
enough genuine economic purpose to pass review. Shelters are hard to detect on
audit; even with improved reporting requirements, many shelters will go undetected.
The government wins most, but not all, shelter cases it pursues, and
there are no meaningful penalties for shelter use. Consequently the decision
whether to use a tax shelter is a gamble that many find worth taking, even if
their behavior may cross the (admittedly, often blurry) line between legal avoidance
and tax evasion. Shelters directly reduce revenue, but the more serious
problem is that awareness that shelters work undermines voluntary compliance.
Some people justify shelters as a do-it-yourself way of converting the income tax
to what many deem superior-a consumption tax. This argument is bogus,
according to Bankman, because tax shelters do not lead to an accurate measure
of a consumption tax base. Bankman explores various potential approaches to
defining business transactions as prohibited tax shelters. While each has flaws,
he argues that the war against shelters must continue, because the failure to
wage it would threaten the capacity to collect taxes not only on capital income,
but also-because of the capacity to transform labor income into capital
income-on labor income as well.
The menu of challenges to tax administrators from international transactions
is "prodigious," to quote David R. Tillinghast. Some of the problems result
directly from the complexity of transactions involving many companies in various
nations operating under different laws and accounting practices and with
many currencies. Income is not defined identically in all nations. The largest
single problem is the incapacity of the U.S. government to require information
returns on various types of foreign-generated income or even to identify people
who must file. Some problems arise from criminal transactions-Enron owned
186 entities chartered in the Cayman Islands. Tillinghast argues that a major
objective in an increasingly globalized world should be to improve the voluntary
exchange of data among governments. The IRS has recently moved to shut
down a large tax avoidance ploy advertised by credit card companies-the use
of debit cards issued to banks operating out of tax shelter countries that do not
share information with the U.S. government. A continuing problem involves
international transactions within commonly owned companies-the so-called
transfer pricing problem. Such companies can set prices to allocate income to
jurisdictions with relatively low tax rates. Tillinghast has high praise for advance-pricing
agreements, in which the IRS and private companies agree in advance
on the prices at which various transactions will subsequently be valued. Tillinghast
cautions that little simplification would likely result if the United States
moved from taxing worldwide income to a territorial principle under which
only income generated within the United States is subject to U.S. tax.
Small businesses receive favored treatment under the tax code, and some argue
that such treatment may be justified, at least in part, as an offset to the regressive
effect of other government regulations that particularly burden small businesses.
But Joel Slemrod argues in chapter 4 that this argument ignores the relatively
high rate of evasion by small businesses, a problem that justifies intensified auditing
and other enforcement measures. Most small businesses report that they lose
money. In part this result reflects genuine unprofitability. But it also reflects willful
evasion, as careful audits show that small businesses have low rates of voluntary
compliance. This is consistent with evidence that shows that the small-business
sector tends to expand when tax rates increase, because this increases the
value of the greater tax avoidance and evasion opportunities in that sector. For the
partnership and some corporation sectors, so-called pass-through entities, non-compliance
benefits a highly affluent slice of the taxpayer population. Slemrod
argues that application of optimal tax principles warrants intensified enforcement
focus on pass-through entities owned by high-income individuals. Indeed
the IRS recently announced a shift in focus toward that sector.
One of the most important innovations in tax administration in recent years
is the advent of software to assist individuals and professionals in computing
their tax liabilities. Austan Goolsbee in chapter 5 examines whether such tax
software has obviated the desirability of tax simplification. His unequivocal
answer is no. Those who do not use tax software are precisely those for whom
the losses from complexity are the greatest. Nor do those who use tax software
do so in order to reduce tax complexity. Rather, use of tax software is a by-product
of other characteristics that dispose the user to be computer-literate.
According to Goolsbee, a much more promising road to simplification would be
to convert the least complex tax form of all-the 1040EZ-to automatic,
return-free electronic filing.
Over the past two decades, the earned income tax credit (EITC) has come to
be the largest federal program of cash assistance to low earners. Unfortunately
noncompliance with the rules of the EITC is widespread among those who
claim this benefit. At the same time, many who are eligible for the benefit do not
claim it. In chapter 6 Janet Holtzblatt and Janet McCubbin examine what to do
about these and other problems confronting low-income filers. Many difficulties
arise from complex and unstable marital and other living arrangements.
Others arise from inconsistent definitions of such important terms as dependent
child in federal programs. Certain "solutions" to the problem of administering
the EITC-such as moving responsibility for refunding monies to an agency
other than the IRS-would do little more than shift the problem's locus. Establishing
a uniform definition of a dependent child would be of some help. A
major challenge is to design rules that would improve compliance without raising
obstacles to application that would reduce the proportion of eligible filers
who receive the credit.
Marsha Blumenthal and Charles Christian report in chapter 7 that more
than 70 million filers rely on tax preparers-2 million of whom file the one-page
Form 1040EZ-to save time and effort and reduce uncertainty. Filers pay handsomely
for this service, more than $10 billion, according to estimates by the
authors. Unsurprisingly practitioners are used disproportionately by the poorly
educated, the elderly, the self-employed, and those with complex returns. When
Minnesota taxpayers were informed that they would be subject to an increased
audit rate, the use of preparers increased slightly. Studies indicate that the use of
preparers is associated with lower voluntary reporting of some types of income
but an increased likelihood that filers will pay estimated taxes in the course of
the year. The former result suggests that preparers may contribute to evasion.
Although tax preparers are subject to IRS regulations and may be fined if they
contribute to inaccurate tax reporting, it is unclear how vigorously these regulations
are enforced. These considerations are of particular importance in the
case of so-called tax shelters, in the design of which accountants and lawyers
often play an active and initiating role. Filers who employ preparers are more
likely than are unaided filers to use electronic filing, a practice the IRS is encouraging.
However, the spread of electronic filing is lagging behind IRS goals.
Frank Cowell, in chapter 8, examines various economic theories of tax compliance
and administration. The earliest models treat taxpayers as gamblers
(TAG models) who weigh the potential monetary gain from successful evasion
against the potential monetary loss if the evasion is detected and punished. The
conclusions from TAG models are that people will evade whenever it pays to do
so. Because it is a gamble, they will evade less if they are averse to the risk of
being audited and punished. They will evade less if the audit rate or punishment
increases. Surprisingly the models do not necessarily predict that evasion rises
when the tax rate goes up. More detailed evidence about the nature and determinants
of tax compliance in practice come from the now-defunct Taxpayer
Compliance Measurement Program (TCMP), a system of extremely detailed
audits-known informally as "the audits from hell." The IRS carried out these
studies until 1988 to determine how best to allocate its limited enforcement
resources. The TCMP revealed behavior that was not inconsistent with the
TAG model but provided more detailed information as well. For example, compliance
rates vary depending on the source of income, marital status, and age.
Some recent research, including laboratory experiments, has cast doubt on the
TAG model, suggesting that norms and framing influence compliance and
shedding light on the contexts under which duty rather than calculation governs
compliance behavior. Cowell suggests that improved theories should encompass
taxpayer motivation and the way business conditions influence business
compliance. They should also allow for the influence of norms and social interactions,
factors that are excluded from TAG models, which treat each individual
in isolation.
Continues...
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Copyright © 2004
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