Fixing Distortions in Taxpayer Behavior: Optimal Tax Compliance Regarding Unknown Basis

Abstract:     
In order to have optimal tax compliance in the field of tax reporting, under our current paradigm, we need clearly articulated but salient standards for record keeping. The popular belief that taxpayers do not need to keep adequate records creates a behavior distortion of noncompliance. This belief is justified by claims that the obligation is either too complicated or just impossible to understand. The resulting behavior by the taxpayer comports with both norms-based theories and deterrence-based theories of compliance. Because taxpayer keep inadequate records courts are left to determine what value to assign to the assets. For 120 years courts have struggled with assigning this value. The uneven application of the record keeping rules causes friction in the most critical area of the tax code, accounting for a large portion of the $285 billion tax gap associated with underreporting. In order to increase compliance and avoid higher tax rates, this Article suggests that the court should adopt a new preliminary determination to decouple innocent taxpayers from culpable taxpayers. This determination would be based on a similar test under Federal Rule of Evidence 104(a) dealing with assertion of privilege. Regardless of whether the court adopts the new rule, the Article concludes with the theory that, rather than a court using its “best guess” to calculate basis, it should adopt one of the following clear tests: (1) mark-to-market approach; (2) modified Auerbach approach; or (3) modified original issue discount (OID) approach.

Number of Pages in PDF File: 70

Keywords: Basis, Cohan, Tax, Underreporting, OID, Auerbach, mark-to-market, tax gap, norms, deterrent, record keeping

JEL Classification: H26, H24, H21, H20, K34, K41, H25

Accepted Paper Series