Alex Raskolnikov (Columbia) has posted his paper on the design of tax penalties, which I briefly blogged about last week.  From the abstract:  "Avoidance and evasion continue to frustrate the government's efforts to collect much needed tax revenues.  This article articulates one of the reasons for this lack of success and proposes a new type of penalty that would strengthen tax enforcement while improving efficiency. ... I propose to complement the existing sanctions with a new penalty equal to a fraction of the legitimate subtraction item (such as a deduction, credit, or loss) reported on teh same line of a return that contains the illegitimate one.  With this penalty in place, the harder it is for the government to find a given avoidance transaction, the higher is the statutory sanction if the transaction is detected.  The proposed penalty adjusts itself." 

Would you be a little bit more careful about valuing your charitable deductions if you knew that one misstep could cost you the whole pile (or half the pile)?  I suspect so.  We taxprofs like to talk about high-falutin' tax shelters, but Alex's paper addresses an important source of lost revenue -- overstated deductions for business expenses, charitable contributions, and so on. 

My biggest concern is that a self-adjusting penalty could change tax planning norms for the worse.  As it is, most tax advisors give honest advice about what the tax law is.  We pretend that our clients would be better off economically following the law rather than playing the audit lottery, and most of us do it with a straight face.  A self-adjusting penalty might encourage both clients and advisors to think strategically, incorporating the likelihood of audit as well as the size of the penalty --- in short, encouraging a norm of gamesmanship in tax planning.  Some degree of gamesmanship is inevitable in tax planning (all tax planning is gaming the gap between economics and the Code) but the gamesmanship should stop short of calculating the likelihood of audit and the size of the penalty. 

Of course, Alex may be right that many tax advisors already encourage clients to play the audit lottery, in which case his proposal surely helps.    

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