Tax Penalties and Deterrence

Determining Effectiveness and Taxpayer Perception

Donald Morris, PhD, CPA, CFE, CFP

Tax professionals are aware of the arsenal of tax penalties available to the IRS. Taxpayers often become aware of tax penalties only when faced with a notice from the IRS, resulting from an examination, the late filing of a return, or the late payment of a tax. Yet penalties are assumed to act as deterrents. The deterrent effect of tax penalties can be questioned from five distinct perspectives. The first involves the much-discussed complexity of the tax code and its effect on deterrence. The second is the IRS's penalty abatement policy, which, in some instances, results in more penalty dollars being abated than collected. The third is the economic model of rationality supporting tax penalties, which assumes taxpayers rationally weigh their odds of detection and the probable economic cost in penalties and additional tax dollars when deciding their level of compliance. The fourth is the practical matter that, in order for penalties to effectively deter noncompliance, they must be known and understood and taxpayers must see that others are being caught and penalized. The fifth relates to how the relative amount of penalties is determined.