Deterrence theory suggests that an increase in penalty rates should increase compliance. There is, however, little real-world evidence that they do. Disproportionate penalties could reduce compliance, if they are perceived as unfair. They could reduce trust for the government and crowd-out intrinsic motives to comply, eroding compliance norms and tax morale. They could also increase disputes, and encourage the government to strain to avoid applying them, thereby reducing economic deterrence. Overly severe penalties could also result in overdeterrence (i.e., reducing the effectiveness of tax incentives), make it difficult to preserve marginal deterrence (i.e., the notion that greater transgressions should trigger larger penalties), and inflict more collateral damage when misapplied.
Some governments have turned to strict liability and nonmonetary penalties instead. In theory, a strict liability penalty can generate more deterrence because it is more likely to be imposed. Strict liability penalties may, however, be viewed as unfair when applied to those who made reasonable, good faith efforts to comply. While strict liability penalties may also seem easier to administer, any apparent administrative savings may be illusory, as penalizing those who acted reasonably probably encourages controversy.
Moreover, even fault-based penalties can be administered as de facto strict liability penalties when taxpayers have the burden to show they are not at fault. For example, when a tax agency automates penalty assessments and requires taxpayers to prove they should not be penalized, it creates de facto strict liability penalties for those who do not or cannot respond. Thus, the automated administration of penalties can pose risks to tax compliance.
Like strict liability penalties, nonmonetary penalties (e.g., disclosing the names of those with delinquencies or revoking their licenses or other privileges) may seem unfair, especially when first introduced, because they are not the norm. They also impose greater social costs than fines. They can, however, leverage behavioral science insights, and emerging evidence suggests that visible, nonmonetary penalties can improve tax compliance in some cultures.
Procedural protections can minimize social costs and reduce the risk that nonmonetary penalties will be seen as unfair. Some governments only impose nonmonetary penalties if the taxpayer: presents an egregious case (e.g., a large or repeated delinquency); is not appealing; has been notified that the penalty may apply to him or her; and has declined to pay, declined to establish he or she cannot pay, and has declined to enter a reasonable payment plan or compromise. These protections may blunt economic deterrence; however, they help ensure that disproportionate penalties are not imposed against those who want to comply. With sufficient procedural protections, visible, nonmonetary penalties may be better than overly severe penalties and strict liability penalties.
Finding new ways to penalize and deter conduct that is the norm, however, probably erodes trust for the government, along with voluntary compliance. To improve the effectiveness of penalties, policymakers should reduce the opportunities for noncompliance so that penalties rarely need to be applied. The government can show that it is legitimate and trustworthy by only penalizing behavior that is clearly outside the norm, enhancing the effect of the few penalties that it does impose. For example, it could penalize those who are outside the norm because they are not trying to comply (i.e., via faultbased penalties). Alternatively, if the government could successfully improve tax compliance norms in an industry (e.g., by requiring tax compliance before granting licenses in cash businesses), then, with appropriate safeguards, it could use nonmonetary penalties (e.g., revoking licenses) to reinforce those norms.