Taxpayer Disclosure and Penalty Laws

Abstract:     
The tax auditing context is illustrative of a more general set of situations in which regulators attempt to extract information from entities over whom they have oversight (Border and Sobel 1987). Hence evaluating the impact of various features of the tax setting can provide important insights into a variety of regulatory environments. One unique aspect of the tax law in the United States that may have implications for other regulatory contexts is the exemption from penalties afforded to taxpayers who disclose reporting positions lacking authoritative support (where the application of tax law is uncertain). This unique provision would seemingly have an adverse impact on compliance if taxpayers respond strategically and take more aggressive reporting positions. Offsetting this effect, disclosure of aggressive positions could make audits more efficient. An evaluation of the impact of the disclosure exemption may provide insights into other regulatory situations where communication is at the discretion of the regulated entity and communication requirements are ambiguous.

This paper reports the result of a game theoretic investigation of the consequences of the tax disclosure exemption. In our analysis, we find that: (1) taxpayers sort themselves out into (at most) three groups based on their type and thus partially signal information through their disclosure decisions, (2) the tax agency?s expected revenue collections (net of audit costs) decline when taxpayers are allowed to exempt themselves from penalties by making disclosures, and (3) the impact of disclosure regulations depends on the taxpayer?s type. Of particular interest is the fact that taxpayers with a low likelihood of successfully defending a questionable deduction decrease their expected payments although they don?t actually disclose in equilibrium. Finally, we find that the amount of resources absorbed by the tax collection process can either increase or decrease when taxpayers have an opportunity to obtain a disclosure exemption, depending on the amount of tax at issue.

Number of Pages in PDF File: 34

JEL Classification: H26, C72, D82

working papers series