The IRS Scandal, Property Rules, and Liability Rules

IRS LogoRegardless of your take on the IRS targeting conservative groups applying for 501(c)(4) status, the episode demonstrates once again that Congress, the Administration, and the media have multiple avenues to pressure the IRS to act or to reconsider earlier actions. This susceptibility to political pressure has broad, counterintuitive implications for how to best deter violations of requirements throughout tax law.

In their path-breaking law & economics article, Calabresi & Melamed observed that every entitlement can be protected by either a property rule (e.g. injunctions, disgorgement of profits) or a liability rule (e.g. compensatory damages). The same is true in tax law. When a taxpayer violates a requirement for a favorable tax status, the tax code either imposes additional tax proportionate to the harm (a liability rule) or imposes the draconian penalty of taking away the tax status entirely (a property rule).

Which rule is most likely to deter a well-connected organization from violating a requirement imposed on it by tax law? At first glance, property rules (i.e. yanking the organization’s favorable tax status) appear to be the most effective deterrent. But the IRS routinely hesitates to take this draconian step, which would result in complaints to Congress, the Administration, the media, and other organizations. Even if the tax code, as written, imposes this property-rule remedy, the IRS can and often does decline to impose it in practice.

Examples of this problem abound throughout tax law. My favorite example is a real estate investment trust (or “REIT”) that had its IPO in 2007 and revealed in its SEC filing that it was in clear violation of one of the requirements (I.R.C. § 856(a)(2)) to qualify as a REIT for tax purposes. How brazen! But what was the IRS to do? The requirement is protected by a property rule: the only remedy available to the IRS was to take away the REIT’s favorable tax status entirely. This would have been draconian. All the REIT’s shareholders would have complained to their congresspersons, the financial press would have run stories, and the National Association of Real Estate Investment Trusts would have raised a ruckus. The IRS didn’t dare impose this property-rule remedy. The IRS did nothing, and the REIT suffered no consequences for the violation.

Would this REIT have been so brazen if the requirement had, instead, been protected by a liability rule, which would merely have imposed additional tax proportional to the violation? Almost certainly not. And that is the counterintuitive result: liability rules are often more effective in practice than draconian property rules in deterring taxpayers from violating tax-law requirements.

The relative merits of property rules and liability rules in tax law are explored in depth by this forthcoming Virginia Law Review article.


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2 Responses

  1. SenatorMark4 says:

    Once again we see the elites arguing about special treatment in the same way that the underclass gets it’s special deals.

    Excess income? Invest it and actually ignore the rules and get a pass. Welfare crack-head mom with 15 kids, ignore responsibility and demand more ‘income, redistributed’.

    The only people that don’t seem to get your attention at this site are the middle class. Wage slaves get their W2. Working contractors (the few remaining) get their 1099-MISC. But all the other people on the end of redistributions don’t get their 1099-GOV in conjunction with their welfare, foodstamps, ag subsidies, etc. It’s an endless list at all levels of government: city, county, state, and fed.

    Until ‘income, redistributed’ gets the same reporting as earned income via 1099-GOV there will be no end to the government corruption.

    It is easier to file for food stamps in neighboring counties than it is to find a job. That says it all.

  2. I always find it interesting to watch the IRS backdown in the face of political pressure and to see under which circumstances that happens; I like your explanation.