Wednesday, January 9, 2013
Tax planning can be highly problematic. It can reduce revenue, produce inefficiency, and allocate tax burdens in an inequitable fashion. As a result, scholars have examined how the tax code often incorporates costs designed to deter tax planning. An influential line of tax scholarship has dubbed these costs “frictions.” In examining and judging frictions, scholars have focused on the central question: When do frictions do a better job at deterring tax planning than causing it to continue in a more costly fashion? However, as I display in this Article, this question is necessary, but not sufficient, to analyze whether frictions are functioning well in the tax system. Just as important is a preliminary set of questions: Does the friction systematically track characteristics of taxpayers engaging in tax planning relative to groups that are not? Does the friction systematically track characteristics other than likelihood of tax planning and how, if at all, does this affect the friction’s desirability? These preliminary questions provide new, analytically important tools for evaluating and designing a whole host of tax provisions. Specifically, I argue that frictions serve as screening mechanisms, meaning that they screen between different groups of taxpayers and impose different costs on different groups. Understanding how frictions are screening between taxpayers and imposing different costs on different groups of taxpayers across the tax system is essential to evaluate both if frictions are deterring tax planning as intended and if they are doing so in an equitable fashion.
While a large economics literature discusses screening mechanisms in optimal tax theory, scholars have not made connections between this literature and the examination of existing tax law frictions. In this Article, I draw on optimal tax theory to explain how frictions inherently serve as screening mechanisms, by tracking various underlying characteristics of taxpayers and imposing different burdens on different taxpayers. I then display how frictions can serve as screening mechanisms on tax planning by tracking relative tax planning motivation and imposing relatively higher costs on tax planners. Recognizing how frictions fill this role can help make them better tailored to do so. Moreover, viewing frictions as screening mechanisms also reveals how existing frictions screen taxpayers based on characteristics other than the likelihood of engaging in tax planning. Understanding how frictions function as screening mechanisms reveals perverse, disparate impacts of such screening and suggests constructive ways to modify frictions so as to eliminate such perversities.
Frictions are as important as tax scholars have long said they are. They impose significant costs on taxpayers and shape behavior. But they are doing more than scholars have recognized. It is time to push beyond the predominant view of frictions as deterrence vehicles and recognize their additional role as screening mechanisms. Doing so raises difficult, but important, questions about how frictions across the tax system differentially affect taxpayers, and how we can better use frictions to better the tax system.