At COST’s annual meeting in San Antonio two weeks ago, I participated on a panel regarding state tax penalties. We focused on a troubling trend: states increasingly using penalties to raise revenue, whether by building them into newly enacted and unusual taxes or by expanding the application of existing penalties. The premise that penalties can double as fiscal tools should make taxpayers and tax administrators uneasy.
Penalties aren’t a fun topic, but they have a legitimate—and limited—place in state tax administration. In voluntary, self-assessment tax systems, penalties encourage compliance: timeliness penalties promote on-time filing and payment; negligence and understatement penalties promote appropriate care in preparing returns; and information-reporting penalties encourage conduct that supports efficient tax administration. Fraud penalties, by contrast, deter intentional evasion and therefore should be the most severe. When a timeliness penalty begins to rival a fraud penalty in percentage terms, the penalty structure is out of balance.
What penalties should not do is serve as an intentional source of revenue generation. The primary purpose of a penalty should be to encourage (or discourage) conduct. State tax administrators should welcome the day when no taxpayer is subject to a penalty. That is why a fiscal note that relies on estimated penalty collections to support state tax legislation is particularly troubling: it gives the government a fiscal interest in continued noncompliance. Once penalties are viewed or used as revenue raisers, taxpayers have little reason to trust that reasonable-cause, good-faith, and other relief provisions will be administered fairly.
No taxpayer wants to be penalized. And no tax administrator should seek to impose a penalty when there is no evidence of misconduct. A sound tax system should impose penalties reluctantly; its goal should be compliance, not collections.