Responsive Regulation and Large Business Tax Compliance

Leigh Osofsky, Getting Realistic about Responsive Tax Administration, 66 Tax L. Rev. __ (forthcoming 2012) available at SSRN.

Leigh Osofsky’s paper, Getting Realistic about Responsive Tax Administration, studies an important feature of tax collections procedure, the IRS’s Compliance Assurance Process (CAP). CAP is a program—piloted in 2005 and extended to all large business taxpayers in 2011—by which the Service reviews the compliance of large business taxpayers prior to the filing of a tax return. The goal here is to resolve all tax positions before the return is filed, and to thereby move from a post-return filing audit system to a pre-filing cooperative conversation between taxpayer and Service. According to Osofsky, supporters tout several supposed benefits of CAP: it reduces IRS resource spending on large businesses, letting the IRS focus its energies on other areas; it helps taxpayers minimize uncertainty and hence compliance costs; it provides the Service with real-time data on compliance issues; it may encourage strong tax compliance norms; and it discourages impermissible tax planning by offering incentives for choosing compliance. Osofsky doesn’t think current empirical evidence is strong enough to allow us to rely on this story. She presents an alternative story: Increased resource wastage by taxpayers resulting from insufficient scrutiny and revenue losses to the government that offset IRS cost savings may mean that CAP is not as appealing as its supporters claim.

As an investigation of CAP, a little-known tax administration procedure for dealing with large business taxpayers, Getting Realistic is already an interesting and timely piece. However, the paper’s true uniqueness lies in its evaluation of CAP in the broader theoretical context of “responsive regulation” and “responsive tax administration” approaches. Responsive regulation is broadly used to denote approaches emphasizing a shift away from traditional, top-down regulation towards more participatory, bottom-up regulation. Osofsky describes its central tenets as including a notion that regulators should use persuasion to obtain compliance, an emphasis on procedural justice to encourage more compliance, and a notion that punishment should only be meted out only after cooperation hasn’t worked. In the tax administration context, the theory emphasizes the importance of understanding diverse taxpayer motivations and of trust building between taxpayers and Service, rather than traditional audit-style penalties. It also focuses on reciprocity and service as ways to increase compliance.

Having placed her critique of CAP within the framework of responsive regulation, Osofsky is able to point out problems with how the IRS is running CAP and to relate these to more global problems with responsive regulation theory and its implementation. First, Osofsky complains that the IRS has inappropriately reduced monitoring of large business taxpayers due to excessive faith in CAP specifically, and responsive regulation more generally, to yield compliance. Osofsky argues that such faith is misplaced because we can’t just count on responsive regulation to deliver higher compliance levels. We don’t know that procedural justice necessarily leads to more compliance. Further, we simply do not know if CAP, in fact, increases compliance. Second, CAP lacks a penalty for taxpayer failures to disclose CAP violations, and thus lacks a mechanism for ensuring taxpayer honesty. This lack of a “big stick” is inconsistent with the tenets of responsive tax administration and creates what Osofsky calls a “test drive” effect, whereby taxpayers get to feel out how the IRS will likely react prior to simply being subject to the same old penalties as everyone else at the audit stage. Osofsky recommends the use of a risk-adjusted, multiplier-style penalty to incentivize taxpayer transparency. Finally, Osofsky critiques the 2011 expansion of CAP to all large business taxpayers at their election as creating a self-selection bias, which leads to misallocation of IRS resources. Osofsky points out that while it may make sense to offer CAP to those large taxpayers who will be subject to continuous audit, it does not make sense to offer CAP to those taxpayers who wouldn’t otherwise be subject to audit.

In examining the mechanisms, potential benefits, and potential limitations of CAP, Osofsky’s paper is an important addition to the growing literature on tax administration and enforcement. Detailed academic studies of CAP and other programs like it are scarce, as is the literature on IRS operations and management and its tax collections policies and procedures more generally. This is too bad because the ways in which the Service goes about collecting taxes equally implicates important tax policy questions, such as efficiency, equity, administrability, and distributive justice. Osofsky’s extremely thorough study of CAP in this paper provides a fascinating addition to this underexplored facet of tax scholarship.

In addition, by placing her analysis of CAP in the context of the responsive regulation/responsive tax administration framework, Osofsky’s work really goes to heart of how the IRS formulates and justifies its tax collections policy choices. One possible story—and the one Osofsky primarily puts forth in this paper—is that policies such as CAP have been implemented in their current form as a result of misplaced faith in responsive regulation theory and its tenets. There are other (related) threads to the story and other possible stories: What is the relationship between faith in responsive regulation and limited IRS resources? Is the IRS moving towards “responsive” programs like CAP primarily because of limited resources? Conversely, is it a lack of resources that is leading the IRS to implement the responsive regulation framework in a less than perfect way? What part does information or expertise asymmetry play in the CAP/responsive regulation story? To what extent is IRS commitment to the CAP program a matter of managing sophisticated taxpayers and transactions in the face of a knowledge gap?

These are vital questions in tax administration, and Osofsky’s paper offers important and interesting insights into some possible answers.