This Article examines the optimal level of tax compliance and the optimal penalty for noncompliance in circumstances in which the tax law is substantively uncertain – that is, when the precise application of the Internal Revenue Code to a particular situation is not clear. In such situations, two interesting questions arise: First, as a normative matter, how certain should a taxpayer be before she relies on a particular interpretation of a substantively uncertain tax rule? That is, if a particular position is not clearly prohibited, but neither is it clearly allowed, under the tax law, what is the appropriate threshold of confidence that the taxpayer ought to have before engaging in the transaction? Second, what penalty regime would give the taxpayer the right incentive with respect to relying on substantively uncertain tax law?

With these questions in mind, the Article shows that, applying standard assumptions from the economic literature on deterrence, the optimal tax penalty regime – the one that would induce the optimal reliance (or non-reliance) on uncertain tax laws depending on the circumstances – would involve (a) a rule of strict liability with respect to taxes owed as well as to the penalty, and (b) a penalty that roughly approximates the famous Bentham-Becker punitive fine, calculated by dividing the harm (here, the underpaid tax) by the ex ante probability that the harm would be detected. The Article also explains why a fault-based approach to tax penalties, under the standard assumptions of the classical deterrence model, would not work as well as the strict liability approach. This is because the fault-based approach has comparatively high administrative costs, cannot properly regulate “activity levels,” and has relatively unattractive distributional consequences. The Article concludes, however, that if Bentham-Becker level penalties or if wide-spread use of tax liability insurance are not feasible, there is a good argument for the use of a fault-based penalty regime, a regime not entirely unlike the one currently in force. The analysis of this Article may have implications for any area of law where the substantive law is uncertain.


Tax Law

Date of this Version

December 2006

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Tax Law Commons