The Dangers of Defanging the IRS

Editor's Note: There are a lot of ideas on how to "fix" taxes, though many conflict with each other and most fail. From around the world, here is one of several current prescriptions.

Seeking revenue to help fill a gaping budget hole, officials in New Jersey two years ago made an offer to tax cheats: Those who owed could come clean and pay up, with no penalties and no questions asked.

The state's tax authorities initially estimated the effort would bring in about $200 million. The final take was beyond their wildest expectations. Tax delinquents came forward with about $700 million.

Now, with a gap of about $345 billion a year between what U.S. taxpayers pony up and what they owe in federal taxes, some analysts say it may be time for the Internal Revenue Service to try a similar tactic. "All of a sudden these people can come out of the darkness, and the government collects a lot of money," says economist Arthur B. Laffer, former adviser to President Ronald Reagan and author of a 2010 book that calls for a federal tax amnesty.

Since the 1980s, 45 states and two cities have enacted amnesties, according to the Federation of Tax Administrators. At the federal level, lawmakers considered the idea in the 1980s and 1990s, though no broad initiative was ever enacted. Limited federal programs have allowed taxpayers to avoid criminal penalties for reporting cash stashed in offshore accounts.

Proponents say a federal tax amnesty would encourage payments from people who haven't come forward because they are afraid of the civil and criminal penalties they might incur. Critics, meanwhile, say it would do more harm than good because taxpayers will lose their fear of the IRS and stop paying taxes, expecting that they could make good the next time the U.S. government offers a reprieve. "It actually reduces compliance with the rules," says Martin Sullivan, an economist at Tax Analysts, a nonprofit publisher of tax information based in Falls Church, Va. "In the long run, it's a revenue loser."

Indeed, the last time congressional tax experts grappled with the issue in the 1990s, they estimated that waiving tax penalties would cost the U.S. $8 billion over 10 years. A 2010 New York tax amnesty netted just $45 million, while state officials had hoped to collect at least $250 million. Critics said the program was not well publicized.

In a way, the debate over tax amnesty comes down to differing views of human psychology. Laffer thinks a federal tax amnesty could bring in a one-time windfall of $600 billion to $800 billion. And far from reducing compliance, he thinks it would increase the likelihood that former tax scofflaws would continue to pay their taxes. "Once these guys are above the ground, they'll never cheat again," he says. Consequently, Laffer estimates federal revenue would increase by about $60 billion a year in the wake of an amnesty.

Yet even advocates of amnesties say they should be carried out carefully: Delinquent taxpayers must be convinced they are getting a one-time opportunity. Tougher penalties must follow the reprieve, to encourage people to come forward. Former IRS Commissioner Fred Goldberg, who also served as President George H.W. Bush's top tax policy official in 1992, says he dislikes the term amnesty. Instead of enacting a short-term program, he says, the IRS should take broader steps to make it easier for people to voluntarily pay delinquent taxes. "If you make a true voluntary disclosure, you should never be subject to criminal prosecution," says Goldberg.

Even that is a matter of debate. Sullivan thinks IRS penalties are a powerful deterrent. "As much as we all hate the IRS, there is something we should really cherish about it, which is that when people fear the IRS, they comply with the law," he says.

The bottom line: A national tax amnesty might raise badly needed revenue. Yet programs at the state level have had uneven results.

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