Tax penalties: Does the IRS need clearer standards for using them?

The IRS’s budget has been going down, not up. These cuts have made the agency less able to play its accustomed customer-service role in helping taxpayers comply with the U.S. tax code.

To be sure, the IRS also has its enforcement side, with penalties, audits, investigations and collection actions.

Could it be, however, that widespread use of tax penalties under the current system undercuts the goal of encouraging voluntary compliance?

A report released last week by the IRS’s own advisory council suggests as much. The report recommends that the IRS perform a systematic review of the penalties it imposes, focusing on how those penalties do or do not encourage voluntary compliance with the tax code.

The number of penalty provisions in the code has proliferated, from 14 in 1955 to more than 170 today. But it isn’t only the sheer number of penalties that is a concern. It’s the fact that the IRS is often inconsistent in how it responds to requests for penalty abatement or other relief.

What often happens is that IRS computers mechanically impose penalties without understanding the circumstances of a particular taxpayer’s situation. This happens, for example, with the IRS’s Automated Underreporter Program.

Mechanical imposition penalties might seem efficient, but in practice it isn’t. For one thing, unfair penalties may make generally compliant taxpayers less willing to voluntarily comply with the tax code in the future.

Moreover, taxpayers have the right to request penalty relief based on a showing of “reasonable cause” for an underpayment. As the advisory council report noted, the IRS needs to do a better job of articulating clear standards for when penalties will be waived.

In short, the primary goal of tax penalties is supposed to be encouraging voluntary compliance, not raising additional revenue. The advisory council report is a timely reminder of this for the budget-strapped IRS.