Probably? Understanding tax law's uncertainty.

• Author: Lawsky, Sarah B.

INTRODUCTION I. INTERPRETING PROBABILITY STATEMENTS A. The Economics of Deterrence: Why Tax Probabilities Matter B. What Statements About Probability' Mean 1. Risk and Frequentism 2. Uncertainty and Subjectivism II. AN UNCERTAIN CHANCE OF CORRECTNESS A. Sources of Uncertainty in Tax Law: Judicial Anti-Abuse Doctrines B. The Meaning of Correctness C. Compliance Under Uncertainty 1. Frequentist Interpretation 2. Subjectivist Interpretation 3. Uncertainty Restated III. THE IMPLICATIONS OF UNCERTAINTY A. Accounting for Disparate Beliefs 1. The Fault-Based Penalty Structure a. Substantial Understatement Penalty b. Reportable Transaction Penalty c. Escaping the Penalties 2. Fault-Based Penalties and Uncertainty a. No Convergence b. The Effect of Governmental Uncertainty B. The Tax Advisor as a Source of Perceived Probabilities: Regulatory Requirements as Debiasing Tools 1. Informing the Expert 2. Justifying the Conclusion 3. Avoiding Overconfidence 4. Group Methods: How Much Does Accuracy Matter? C. Uncertainty Aversion: When Not Knowing Is the Penalty 1. Uncertainty Aversion Defined 2. Uncertainty Aversion and Probability of Audit 3. Extending Uncertainty Aversion: Uncertainty Aversion and Ambiguous Law CONCLUSION INTRODUCTION

Economic approaches to analyzing legal problems can provide helpful insights by applying a set of familiar analytical approaches to reach conclusions that would otherwise be nonobvious. However, if economic models are used to support specific policy recommendations, the assumptions and definitions underlying these models must be made explicit and evaluated, particularly because those models have become so familiar and are too often applied without sufficient reappraisal of their underlying assumptions, strengths, and weaknesses. Rooting out and understanding the components of economic models is particularly important in tax law, where economic analysis has become a predominant method of analysis.

One core claim of economic analysis is that individuals tend to act in their own self-interest: individuals weigh the costs and benefits of a given action and act when the expected benefits of that action outweigh the expected costs. A corollary of this insight, as famously stated by Gary Becket, is the idea that the optimal sanction to impose on lawbreakers depends on both the expected harm to society created by the unlawful act and the probability that the lawbreaker will be apprehended. (2) This basic model has been analyzed and expanded in the tax context by a slew of economists and, more recently, legal scholars, both in more formal papers and as a basis for broad-stroke proposals. Relying on the basic model, David Weisbach uses the idea of marginal deterrence to propose an optimal level of judicial anti-avoidance doctrines such as the economic-substance and business. purpose doctrines. (3) Alex Raskolnikov, taking a more conceptual approach, argues that the economic calculus of deterrence suggests that penalties should be higher for tax evasion that is difficult to detect. (4) There are any number of additional examples. (5)

Some scholars acknowledge that specific recommendations based on these models are only "second best" approaches. Raskolnikov, for example, acknowledges that some underlying assumptions of economic theory remain "controversial" and that his goal is not to create an ideal tax system, but merely to remove "obvious flaws." (6) In its strongest version, though, the claim is that economic models are the best method for creating tax law policy. Thus, Weisbach writes that "[to] use an economics approach to answer a question normally addressed only by lawyers ... is, in my view, the right way to approach tax law policy." (7) Given the centrality of economic analysis to tax scholarship and policy, it is crucial to understand the assumptions and definitions underlying that analysis. (8)

This Article analyzes one concept crucial to the economic approach as applied to tax law: the meaning of probability statements in scholarship addressing civil tax penalties. This definition is both theoretically and practically important. From the theoretical side, one core assumption of a law and economics approach is the validity of expected-utility theory: that an individual takes only those actions that she believes will increase her own welfare. (9) Put another way, an individual takes an action only when the benefits of that action outweigh the costs. But the expected benefits and costs of an action depend on the relative probabilities of the various outcomes of that action. Understanding the meaning of probability statements thus sheds light on the basic terms of the law and economics argument.

Moreover, it is particularly important to understand the meaning of probability statements in tax law (as opposed to other areas that may be subject to economic analysis) because of tax law's uniquely problematic types and degrees of uncertainty. It is often unclear ex ante whether a position will (or should) be subject to a penalty ex post, and this uncertainty, or chance of incorrectness, has been incorporated into the law itself. Taxpayers who take positions that are less likely to be correct are subject to higher penalties, and tax advisors are often called upon to protect taxpayers from these penalties by providing opinion letters stating that the taxpayers' positions have a certain probability of being correct. (10) Thus, understanding the meaning of probability statements can help structure a more effective penalty system.

With a few notable exceptions, (11) however, legal scholarship has not focused on the question of what probability statements mean. This lacuna exists even though law and economics has become increasingly important in the legal academy and even though the meanings of probability statements and the implications of those various possible meanings have received sustained attention in the economics (as opposed to law and economics) literature. Indeed, a discussion of the meaning of probability statements has been completely absent from the tax-compliance legal literature (12)--even those articles that take as their framework the Beckerian approach to compliance. Many articles fail to provide any definition of probability, while other tax-specific articles simply equate the probability of sanction with the fraction of taxpayers who are audited. (13) But defining the probability of sanction as the chance of audit, or even as the chance of detection, might be close to accurate if every tax-reporting position were either clearly wrong or clearly right. In that case, either there would be no chance of a penalty's being imposed due to the position, or the chance of a penalty would be primarily determined by the chance that the position would be detected. But tax law is complicated enough that it is unclear whether some tax positions are in fact wrong. Indeed, many tax positions that are eventually struck down by courts adhere to the letter of the statute. (14) In other words, because tax law is uncertain, to equate the probability of sanction with the chance of detection is a vast oversimplification.

This Article uses insights from economics and the philosophy of mathematics to argue that many statements about tax probabilities are best interpreted as statements about belief, not as statements about the number of times a particular event will happen in the long run. Interpreting tax statements as statements about belief changes a number of widely accepted conclusions in the tax literature. As this Article shows, this interpretation adds a new complication to optimal tax modeling that may reverse other legal scholars' results, supports recent controversial laws relating to tax advisors that have changed tax law practice, and, counterintuitively, cautions against making tax law more certain.

Part I frames the problem of interpreting probability statements. Section I.A explains why probability statements are key to a law and economics analysis of tax compliance, and Section I.B explains two ways to interpret statements about probability: frequentist and subjectivist. A frequentist interpretation takes a statement about probability to describe the number of times a given event will occur over the long run out of the number of times that it could occur. A subjectivist interpretation takes a statement about probability to describe the speaker's belief about whether the event will occur. Part II addresses what it means for a tax position to have a certain chance of being correct. A position is "correct" for penalty purposes if it would be upheld by a court. This Part argues that statements about the likelihood that a particular tax position would be upheld by a court should be interpreted as statements about beliefs: that is, that these statements should be given a subjectivist interpretation. Part III lays out three possible implications of the subjectivist interpretation for tax-compliance practice and theory. Section III.A gives an example of how systematically disparate beliefs about the probability that a tax position is correct can lead to unexpected results in economic modeling. In particular, if lawmakers and taxpayers have different views of whether tax positions are correct, a welfarist approach may, contrary to arguments other academics have made, actually support fault-based penalties. Section III.B describes how a subjectivist interpretation of tax probability statements provides another justification for regulations that impose rigorous requirements on the substance of legal opinions provided by tax advisors. Section III.C suggests that, given the subjectivist interpretation of tax probability statements, if taxpayers are averse to uncertainty, making tax law more predictable might actually decrease compliance.

1. INTERPRETING PROBABILITY STATEMENTS

   1. The Economics of Deterrence: Why Tax Probabilities Matter

      In the typical economic model of individual utility...