When Can Concentrating Enforcement Resources Increase Compliance?

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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.

 

Comments

  1. Ron Wiener says

    I was intrigued by your post this morning summarizing your ideas as to how the IRS might more effectively increase compliance among low-compliance micro-populations of taxpayers. I’ve downloaded the draft of the full article, but I’m not sure when I’ll have time to read it. But this is a topic I’ve been interested in for about 25 years, so I wanted to reach out and “get acquainted.”

    When I was on the “Compliance Subgroup of the Commissioner’s Advisory Group in 1992-1994, I was able to delve a little bit into the IRS’s then-early efforts at “compliance research.” There hadn’t been a comprehensive TCMP aimed at 1040s for 5 years, and there was concern about the “Tax Gap,” especially the small business and self-employed portion. During my term, the Examination Division created a position for a director of Compliance Research. The IRS was hampered in its ability to justify assigning resources to test the effectiveness of any proposed compliance initiative by the absence of reliable data on levels of compliance before and after the proposed initiative. Without the research, the IRS was subject to criticism for “targeting” one or another group of taxpayers, even if there seemed to be a sound basis for suspecting a high level of noncompliance. It’s my impression that this problem persists.

    There have been some research-driven initiatives [known for a time in SB/SE as “Compliance Initiative Projects” – CIPs – if I remember correctly]. Permission would be obtained to examine a small sample of returns of a population believed – on the basis of some “evidence” of noncompliance – to be worthy of study. A simple example of this technique would be where there had been evidence from prior tax examinations that clients of a particular tax return preparer had a high level of noncompliance in a specific category, such as overstated deductions. A 30-return sample would then be examined, and if the noncompliance pattern was confirmed then a larger sample [e.g., 150 returns] would be examined. If this also confirmed the pattern, the service might examine more of the preparer’s clients and also open a proceeding of some kind against the preparer and/or his or her firm.

    A specific project I remember that was being undertaken in the early-mid 1990s under IRS National Office supervision was a sample of gasoline service stations in two specific small areas in California. The initial groups of Form 1040 returns with Schedule Cs was pulled for audit and assigned to groups of revenue agents. They were given the taxpayers’ returns for the three prior years, to allow the agents to see the pattern of reporting. As I remember, there was an unusually high proportion of the sample that showed Schedule C net income/loss in the range of +/- $25,000, with very little other positive income reported. Schedule A deductions sometimes equaled or exceeded the positive net income [and net cash flow] from the business. The revenue agents were even driven around by the supervisors of the project to the residences of some of the taxpayers, to estimate the values/costs of the homes, the cars in the driveways, and the living costs in those residential areas. It was pretty clear that the reported income wouldn’t sustain the lifestyle. [This project actually was part of an initiative initially called “Economic Reality” and later “Lifestyle” audits. There was over-zealous implementation by at least some of the IRS revenue agents, including asking taxpayers to respond to intrusive questions about their personal financial situation even absent any reason to suspect under-reporting of income or any other kind of tax fraud. This created quite a furor and was effectively curtailed by Congressional lgislation.]

    My limited personal experience as a practicing tax lawyer and a participant in IRS-practitioner liaison activities was that word got around an industry pretty quickly if the IRS started focusing on questionable tax practices of that business. I seem to recall that auditing auto dealer inventory issues was one initiative of that kind. As a result, I came to believe that narrowly focused compliance initiatives, with proper publicity among taxpayers and tax return preparers, would be successful in encouraging increased compliance. I thought that key components of a successful project would include both announcing in advance that the IRS would be focusing compliance efforts on a particular issue/population and then following up with actual and effective audits of the taxpayer population to see how compliance was impacted. I even presented a written proposal to pursue this kind of approach to the IRS Commissioner when my term on the CAG ended. I tried to jump-start the testing of the concept with some initiatives to be implemented by the Philadelphia Chief of Exam and the IRS National Office’s Compliance Research Director. After a short time, I was told about the chicken-and-egg obstacle to starting any specific project: Without the non-existent baseline compliance evidence, there was no research-based way to justify and validate the resources to be devoted to any proposed initiative. That was the last I heard of it.

    Anyhow, the bottom line is that I earnestly hope your approach will bear fruit and will justify and incentivize the exploration of micro-compliance initiatives by the IRS. This would support the business case for allocating the necessary resources [i.e., funding] for some tests of the methodology. If the technique could be proven to be effective as well as “objective,” it might be able to get the support needed by those inside the IRS and its outside stakeholders.

    I’m looking forward to meeting you some day. Let me know if you plan to attend the ABA Tax Section’s May Meeting in DC.

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