When Can Concentrating Enforcement Resources Increase Compliance?

Today’s guest post is by Leigh Osofsky, who is an Associate Professor of Law at the University of Miami School of Law. The post is based on her article Beyond “Worst-First” Tax Law Enforcement, which is forthcoming in the Florida Tax Review. In this post and more fully in her article, Professor Osofsky make a convincing case that IRS should more deeply consider focusing its scarce resources on smaller segments of the population. Professor Osofsky draws insights from economic theory, criminology (including hot spots policing), behavioral economics, and psychology. What makes the paper so compelling is that she cogently explains the research in other disciplines, synthesizes the insights to come up with her own microdeterrence theory for tax compliance, and then applies the theory to a particular problem, cash business underreporting. The theoretical and practical combination is difficult to achieve. Other works by Professor Osofsky have also looked at tax administration, and include critiques of responsive regulation and the use of uncertainty as a tool to reduce the tax gap. Those other articles can be downloaded for free on SSRN and can be found here.  

This post continues our theme of highlighting creative approaches to reduce the tax gap, which we started last week with a post by Susan Morse on the use of narrative.   We will continue to feature the works of interesting and important scholars who tackle issues of tax administration and tax procedure. Les

Gary Becker revolutionized the legal literature with his theory of deterrence.  Becker explained that deterrence can be seen as a function of two main factors: the likelihood of detection and the size of penalties.  His work has spawned decades of scholarship focused on the optimal likelihood of detection and size of penalties.

However, in practice, it is often impossible to increase substantially the likelihood of detection across a population or the size of penalties.  The cash business tax sector provides a striking example of a situation in which there is unlikely to be a substantial increase in likelihood of detection or the size of penalties, despite widespread evasion of tax liability.  In such situations, we are left with the question: Is there any hope of substantially increasing compliance with the law?

In a recent article, Beyond “Worst-First” Tax Law Enforcement, I suggest that, under certain circumstances, it may be possible to increase compliance by concentrating enforcement resources in the form of enforcement projects, which will rotate throughout the population.  I call this process “microdeterrence.”  The central intuition of this article is that, in certain cases, microdeterrence might be able to increase compliance above what would be possible by applying enforcement resources on a uniform basis across the population.

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The article has some foundation in the policing practice of hot spots policing and it may help us understand and improve existing tax enforcement.  Indeed, the IRS already acknowledges using project-based enforcement to direct some of its enforcement resources.  And other countries, such as the United Kingdom, have engaged in a carefully designed program of rotating “tax campaigns,” which focus on specific taxpayers and tax issues. Such projects have targeted particular industries at particular times, such as, in the case of just one example, a taskforce focused on security guards, bouncers, and their employees in London and the South East.

So, what is the case for microdeterrence?  As an initial matter, Henrik Lando and Steven Shavell, Edward Lazear, Jan Eeckhout, and others suggest that an economic case for concentration of enforcement resources can exist when compliance incentives would otherwise be inadequate.  In an extreme case, spreading enforcement resources across the population may yield no compliance because no individual would have a sufficient monetary disincentive to violate.  In such a case, compliance would increase by concentrating enforcement on a smaller subset of the population.  The economic theory dictates that enforcement resources should be concentrated on the largest subset of the population, such that that subset just has sufficient monetary incentive to comply.  More complicated economic models can suggest a case for concentration in other situations, such as when regulated parties do not have the same on / off parameters for compliance, or when potential compliance falls along a continuum (such as a range of possible income reports).

Other factors can increase the case for microdeterrence.  First, Mark Kleinman’s work helps illustrate how rotating enforcement projects can help increase compliance when the expected costs of noncompliance for any individual depend on the rate of compliance of the population.  In such situations, an enforcement project in a given subsector may raise rates of compliance in that subsector high enough to help sustain compliance going forward.  Similarly, work by Robert Cooter and others suggests that norms can enhance the case for microdeterrence when norms affect compliance but themselves depend on minimum rates of compliance.  In such cases, to the extent that local norms are particularly powerful, enforcement projects can help create compliance, which may activate norms of compliance.  The norms may help sustain compliance as enforcement projects move onto the next subsector.  Psychological factors, in particular uncertainty aversion and the availability bias, can also support microdeterrence.  As explored by Daniel Ellsberg and many others, individuals often exhibit an aversion to uncertainty, or unknown probabilities regarding a gamble.  Microdeterrence arguably makes an enforcement regime more uncertain by creating a substantially higher or lower probability of enforcement, depending on whether or not one is subject to an enforcement project.  To the extent that individuals experience uncertainty aversion, the greater uncertainty may yield higher compliance.  The availability bias may similarly leverage psychological factors to increase compliance.  The availability bias is a tendency to use salient events to judge probability.  To the extent that microdeterrence makes enforcement more salient, it may increase the perceived probability of enforcement, thereby increasing the perceived cost of noncompliance.  Finally, evidence from hot spots policing suggests that, to the extent that nodes of noncompliance can be identified, microdeterrence would work best by focusing in particular on such nodes.

After setting forth the theory behind microdeterrence, my article examines how the practice might apply to the particularly problematic cash business tax sector.  For a number of reasons fleshed out in the article, I argue that microdeterrence might help stem the widespread evasion in the cash business tax sector.  Of course, careful application and empirical evaluation would be needed to confirm when microdeterrence does, in fact, increase compliance.  However, a theory of microdeterrence is necessary to determine when it makes sense to apply microdeterrence experimentally.  This article develops that theory and suggests the merits of testing microdeterrence in the cash business tax sector.  Most fundamentally, this article argues that allocation of enforcement resources should be viewed as a crucial, third lever in deterrence theory, and shines light on this lever.