Accuracy-related penalties are supposed to promote voluntary compliance. Congress has directed the IRS to develop better information concerning the effects of penalties on voluntary compliance, and it is the IRS’s official policy to recommend changes when the Internal Revenue Code (IRC) or penalty administration does not effectively do so. The objective of this study was to estimate the effect of accuracy-related penalties on Schedule C filers (i.e., sole proprietors) whose examinations were closed in 2007. TAS compared their subsequent compliance to a group of otherwise similarly situated “matched pairs” of taxpayers who were not penalized. TAS used Discriminant Function (or “DIF”) scores — an IRS estimate of the likelihood that an audit of the taxpayer’s return would produce an adjustment — as a proxy for a taxpayer’s subsequent compliance.
While all groups of Schedule C filers who were subject to an examination assessment improved their reporting compliance (as measured by reductions in their DIF scores), those subject to an accuracy-related penalty had no better subsequent reporting compliance than those who were not. Thus, accuracy-related penalties did not appear to improve reporting compliance among the Schedule C filers who were subject to them. Further, penalized taxpayers who were also subject to a default assessment or who appealed their assessment had smaller reductions in DIF scores, suggesting lower reporting compliance five years later as compared to similarly situated taxpayers who were not penalized. n2 Similarly, those whose penalty was abated had smaller reductions in DIF scores, suggesting lower reporting compliance five years later as compared to taxpayers whose penalty was not abated.
n2 Except as otherwise indicated, all differences discussed in this report are statistically significant (with 95 percent confidence). We note, however, that the DIF is an approximate measure of reporting compliance, and small differences, although statistically significant, may not indicate a real difference in reporting compliance
Prior research suggests that a taxpayer’s perception of the fairness of the tax law, the IRS and the government drive voluntary compliance decisions, and the findings of this study are consistent with that research. Taxpayers subject to default assessments may be more likely to feel the penalty assessment process was unfair, which may have caused lower levels of future compliance. Similarly, those who appeal may be more likely to feel that the actual result was unfair, which may have caused lower levels of future compliance. Finally, those subject to a penalty assessment that is later abated may also feel that the IRS initially sought to penalize them unfairly, potentially causing lower levels of future compliance.