Yearly Archives: 2012

Responsive Regulation and Large Business Tax Compliance

Jun 1, 2012 Shu-Yi Oei

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.

No Option: Thinking Through Elections

Apr 16, 2012 Kim Brooks

For the most part, I prefer less choice.  More choice can lead to less time and less pleasure.  Think about the decision to stay in or go out for dinner.  You look in your cupboards and there isn’t much.  Perhaps a can of tomato and rice soup.  So, you think, maybe it’s a good idea to go out.  But where?  Sometimes brainstorming the options alone is daunting, and after generating a list I simply decide to stay in.  And that’s a good outcome.  In a less ideal case, I’ll spend several hours on the internet, reading reviews of restaurants, looking at menus and prices, calling friends for views, only to become so daunted by the options and by the lack of an obvious “winner” that I’ll stay home.  I will never regain that time.  Worse yet, I do all that research – the internet research and calls – and I chose something.  But when I go to the restaurant it’s a disappointment.  I spend the night wondering if I could have made a better decision.  Cream of tomato soup with rice, and three extra hours, would be preferable.

In “Choosing Tax: Explicit Elections as an Element of Design in the Federal Income Tax System,” Heather Field approaches the issue of the role and value of explicit tax elections.  Apparently more than 300 explicit tax elections litter the Internal Revenue Code.  Field explains that an explicit election is a case where multiple possible tax treatments might apply to a single economic event.

The article makes three main contributions to the literature.  First, Field draws parallels between the tax planning critiques of implicit elections (where taxpayers are left free to opt in or out of particular tax regimes by redesigning their transactions) and the tax planning consequences of implicit elections.

Second, she provides a taxonomy of functions for explicit elections – reconciling discontinuous regimes, facilitating tax classification, promoting simplicity and ease of administration, and condoning tax planning.  Drawing from the wealth of Field’s examples, let me illustrate each.  An explicit election may be used to reconcile a discontinuous regime.  For example, a taxpayer may buy the shares or assets of a business.  At the end of the day, in each case the taxpayer has bought the business.  But the tax consequences that flow from the decision to make one choice over the other are very different.  Nevertheless, in some cases section 338 of the Internal Revenue Code allows the taxpayer to elect to treat a share purchase as an asset purchase.  The objective:  to offer the taxpayer the chance to treat two similar transactions the same for tax purposes.

An explicit election might be designed to facilitate tax classification.  These kinds of elections appear where a taxpayer’s activities might be characterized along a continuous spectrum – say, from corporate to non-corporate form.  Adding an explicit election to enable entity classification may help taxpayers address the difficult classification issues that arise in the middle of the spectrum, where very little differentiates one type of organizational arrangement from another (think check-the-box).

Elections that promote simplicity and administrability improve the ease of compliance or enforcement.  For example, making a flat standard deduction available to some taxpayers provides some record-keeping ease.

The final category in Field’s taxonomy:  condoning tax planning.  Some explicit elections allow taxpayers to achieve a complement of economic benefits that best fit their personal profiles.

Finally, Field delineates some recommendations for the design of explicit tax elections. They might be designed with default rules (so you only need to elect out of them), they may have eligibility limits, they may require technical guidelines, and in their design the policy-maker needs to be attentive to the risk of abuse.

At the end of the day, Field doesn’t make a decision about whether to stay in and eat soup or to go out for dinner.  That’s up to the reader.  So you should read the article and form your own view.  I’ve at least saved you the time in deciding whether or not to do that.

Tax Ethics: Advice from the Past

Mar 5, 2012 Donald Tobin

Major cases in the news from tax shelter promotions to corporate accounting abuses have once again put the ethical obligations of  lawyers, and specifically tax lawyers, onto center stage (or at least in the wings).  Congress passed increased standards for return preparers and the Treasury has followed with increased preparer standards in Circular 230.

It is within this framework that I read Professor Michael Hatfield’s article, which examines the ethical debate and discussions by some of the leading scholars and practitioners during the 40s, 50s, and 60s.  These tax lawyers were at the forefront of discussions regarding the modern income tax.  Professor Hatfield’s historical examination provides us with insight into what they were thinking, and provides us with food for thought as we examine modern ethical problems. Professor Hatfield’s point is just that, to provide us with food for thought.  He does not attempt to draw conclusions from this debate regarding what we should do now.  Instead, he carefully and thoroughly outlines the debate at the time and leaves us with opportunity to draw our own lessons from the analysis.  What is clear from the article is that the leading tax lawyers of the time were as conflicted as we are today on many issues, especially the question whether tax lawyers had a special “duty to the system.”  Interestingly, however, they were almost universal in their agreement on two major points: (1) that the payment of taxes was a civic duty, one which had a strong patriotic element, and (2) tax lawyers had a duty to be proponents, reformers, and educators about the tax system.

Professor Hatfield starts his analysis by reminding us that these commentators were thinking about tax issues in the context of victory in World War II and the rise of communism.  Communism was thought of as the next great evil, and commentators believed that a just and fair tax system was essential to a strong capitalistic economy – the strength of which was necessary to defeat communism.

The historical analysis with regard to a tax lawyer’s duty to the system versus the duty to a client is very similar to the debate the tax bar has had since 1965.  With regard to the duty of tax lawyers almost all commentators concluded that once a taxpayer was involved in a tax controversy, a tax lawyer had no special duty to the system.  A lawyer in a tax controversy owed the client the same duty as other lawyers engaged in litigation.  A tax lawyer’s duty in the prelitigation stage, however, was more divisive. Several commentators including Mortimer Caplin (Caplin & Drysdale) argued for a need for “authoritative guidance in the prelitigation of tax practice.”  Professor John Maguire (Harvard) called for a full examination of “the tax lawyer’s special obligations.” He analyzed the issue based on the tax controversy/planning distinction often used today.  He argued that when the tax lawyer was acting as an advisor, he had a higher duty to the public interest.  Maguire felt such a duty was essential in light of the system of voluntary compliance. Professor Edmond Cahn (NYU) expressed concern that “lawyers were becoming the ‘jackals of the bourgeoisie,’” and Professor Jerome Hellerstein (NYU) argued that tax lawyers have a special duty to both the system and to the client, and pushed for increased disclosure as a means of preventing fraud and abuse.

Others, including Professor Boris Bittker (Yale), Mark J. Johnson (New York practitioner), and Professor John Potts Barnes (Virginia) found no special duty of tax lawyers in any situations.  Hatfield explains that these commentators staked their analysis on the high degree of ethical responsibility that all lawyers faced.  It was not that they were against a high standard for tax lawyers, but that they believed there was a high standard for all lawyers.

Professor Hatfield next examines the historical literature in light of world conflicts.  International conflicts and the threat to capitalism and democratic institutions influenced commentators to view the payment of tax as a means of upholding our democratic values and our democratic system.  As America confronted wars in Iraq and Afghanistan, the President and Congress seemed more afraid that the increased collection of revenue would decrease the support of these conflicts.  Paying taxes did not garner the same type of patriotic fervor it did Post-World War II.  Not only was there not a patriotic push for taxes, but there was a significant push for lower taxes during this period.

Finally, Professor Hatfield’s historical analysis also sheds light on a view, almost universally shared by commentators, that tax lawyers have a duty to engage in public activity to improve the tax system.  This view of “duty” has been shared by leaders in the tax bar since the 1940s (this may be why they are leaders.)  Interestingly, just this week, at the ABA Tax Section Mid-Year Meeting, Professor Kleinbard from the University of Southern California joined with others to present a challenge to the academic community attending the Teaching Tax program to help educate voters about tax policy and budget choices, as Congress and President deal with significant budget challenges.  Professor Hatfield’s historical reminder coupled with Professors Kleinbard’s immediate challenge, is a nice reminder to us all about the tax community’s professional duty to engage in public activity to improve the system.

Professor Hatfield’s historical analysis is a fun-filled stroll through yesteryear.  It provides us a brief glimpse as to “what they were thinking” as the foundation for the duties facing tax lawyers was developed, and reminds us of our public obligations to both support the success of the system of voluntary compliance and to use our expertise to work for a better system.