Tax Penalties and Tax Compliance

Abstract

This paper examines the relationship between tax penalties and tax compliance. Conventional accounts, drawing from deterrence theory and norms theory, assume that the relationship is purely instrumental - that the function of tax penalties is solely to promote tax compliance. This paper identifies another aspect of the relationship that generally has been overlooked by the existing literature: the function of tax penalties in defining tax compliance. Tax penalties determine the standards of conduct that satisfy a taxpayer's obligations to the government; they distinguish compliant taxpayers from non-compliant taxpayers. This paper argues that tax compliance in a self-assessment system should require the taxpayer to report her tax liabilities only on the basis of legal positions that she reasonably and in good faith believes to be correct. However, the accuracy penalties provided under current law set much lower standards of conduct. In the case of a non-abusive transaction, current law allows the taxpayer to base her self-assessment on a position having as little as a one-in-five chance of prevailing; for an abusive transaction, the taxpayer only needs a reasonable belief that her position is more likely than not to prevail. The paper describes reformed standards of conduct for taxpayers, tax practitioners, and government officials that define tax compliance more appropriately for a self-assessment system.

Keywords: tax, tax penalties, tax compliance

JEL Classification: K34