The Weight of Probability, the Cloud of Uncertainty, and More
A.J. Sutter asks whether all tax probabilities are created equal. He suggests that for very basic advice (for example, the permissibility of a home office deduction), the advisor’s opinion might be based on how many times his clients have gotten into trouble when audited, but for more exotic structures, it would be harder to estimate the chance that a court would uphold the transaction, because there wouldn’t be as much experience for estimating prior probabilities. I think this is right, but I’m not sure it means that we necessarily know the probability of success of the more common transaction, in a frequentist sense. Rather, I think Sutter’s point gets at the idea of the Keynesian idea of the “weight” of a given probability: that an argument has more “weight” than another when it is based on more evidence. And his point also highlights one of the problems with relying on tax advisors for your probability estimates: you’re not just getting a probability estimate, you’re also getting the tax advisor’s level of certainty about his estimate, and also, because the tax advisor will be liable if he really messes up, the probability number might have moved based on the tax advisor’s risk aversion. And you, the taxpayer, have no way of disaggregating those numbers.
Sutter also points out that some taxpayers might have more uncertainty aversion than others do, and, more importantly, some types of taxpayers might have more uncertainty aversion than other types. This certainly seems possible, and it would be great to see some empirical work on this. I want to be careful, though, that we distinguish between risk aversion and uncertainty aversion. Even if a wealthy, tax-shelter-loving taxpayer likes to “roll the dice,” he still might not like to play if he doesn’t know what the odds are–that is, he might like risk and not like uncertainty. One more small point on Sutter’s comment: most ambiguities are not likely to be resolved, at least not as long as the standard is what a court would do if the transaction were reviewed. The vast majority of transactions are never reviewed by a court, because most audits settle.
Finally, billb is concerned that high levels of uncertainty are likely to inhibit both legitimate and illegitimate transactions. First, let’s get a better sense of what “high levels of uncertainty” means. We can imagine uncertainty as a sort of plus/minus around a particular probability of success–a cloud of probability, of sorts. For example, we might imagine a highly uncertain transaction to be a transaction about which a tax advisor can say only, “Well, I think there is somewhere between a 10% chance and a 50% chance that a court would uphold that transaction, but I can’t be any more specific than that.” (One study that examined how subjects reacted to increased vagueness about whether a tax deduction would be disallowed created conditions of uncertainty either by including a statement from an accountant that “I am very unsure and hesitate to guess” about the probability that the deduction would be disallowed; to create risk, they included a statement that the given probability that a deduction would be disallowed was “exact.”)
At any rate, we might be able to manipulate levels of uncertainty so that we didn’t deter legitimate transactions, depending on what we mean by legitimate. For example, if the IRS doesn’t want anyone engaging in transactions that have a less than 50% chance of being upheld, and if it turned out that individuals who were engaging in transactions likely to be struck down were uncertainty averse, the IRS could increase uncertainty on the “bad end” of the compliance spectrum, but reduce uncertainty when the chance of success was higher. (For an interesting article about how we might apply uncertainty aversion in law, albeit non-tax law (you know it kills me to recommend a non-tax article), see Tom Baker, Alon Harel, & Tamar Kugler, The Virtues of Uncertainty in Law: An Experimental Approach, 89 Iowa Law Review 443 (2004); it presents the results of a non-tax experiment that suggests that uncertainty with regard either to the size of a sanction or the probability of detection increases deterrence.)