What is Indiana doing wrong?

The Indiana State House voted 60-30 to send House Bill 1004 to Governor Mitch Daniels. The tax amnesty bill would waive unpaid interest, penalties, and fees upon payment of delinquent taxes. Governor Daniels is expected to sign it.

Expert perspective: “‘To err is human, to forgive is divine.’ Indiana has taken Alexander Pope’s words to heart and will provide an amnesty for those who have not paid state taxes on time—or at all,” says public finance expert and SPEA professor John Mikesell. “Our tax cheats will be given eight weeks sometime before July 2006 in which they can pay the taxes they have previously evaded without facing the normal punishments for non-payment.

“Is it really a good idea to extend forgiveness to tax cheaters? An amnesty does, after all, give a special preference to those people who have evaded their taxes. On the other hand, the Legislative Services Agency estimates that the amnesty could yield $103 million, and we all understand that Indiana state government needs the money to deal with its difficult fiscal problems.

“Indiana is far from the first American state government to have offered a tax amnesty. Since 1982, forty-one states plus the District of Columbia have offered amnesties, some more than once, and these amnesties—in Illinois and New York—have yielded as much as half a billion dollars. But are they a fair deal for honest taxpayers and how happy should state governments be about the money from the amnesty? As is usually the case with government policies, it all depends on the details. Did Indiana consider those details when it finally decided to run its own amnesty? If you aren’t going to be first, at least you should try to be the best. As often is the case, Indiana can claim neither to be first nor to be the best.

“What has Indiana done wrong? The problem is rooted in the fact that the amnesty extends to all unpaid tax, including: liability from taxpayers the state has never heard of—businesses that have never registered with the revenue department, never filed a return, nor paid any tax or individuals who have never filed an Indiana income tax return—liability from businesses and individuals who have filed returns but have understated their liabilities, and liability from taxpayers who have unpaid liabilities already discovered and established by the revenue department (often referred to accounts receivable—but there is an exception for riverboat gaming income tax owed because of a recent court decision).

“The first two categories should be the basis for any amnesty; given the limited resources available to any revenue agency, those liabilities may never have been discovered and collected through the Department of Revenue’s enforcement efforts. Collecting these taxes amounts to new money to the state and, particularly in terms of the first category, could generate tax revenue for years into the future as new filers are brought into the system: if the taxpayer gets into the system once, it is likely that it can be kept there.

“But that is not the case with the last category. These liabilities are known (they may even be posted on a Department of Revenue Web site for all to see) and, assuming sufficiently strong enforcement resources are available, they will eventually be collected from the delinquent taxpayer. Those collections aren’t new revenue to the state budget, they’re merely being received a bit earlier through the amnesty and money collected in the amnesty period represents money not collected in a later period. Indeed, normal procedures would yield more revenue from those liabilities than would the amnesty because normal procedures would have also brought revenue from penalties and interest. That break might not seem fair to an honest taxpayer. Also, this means that the $103 million, assuming that it arrives into amnesty coffers as estimated, isn’t all new money to the state budget.

“The second problem involves what is forgiven. No state amnesty has forgiven taxes owed (although tax departments do sometimes negotiate away liability in settlement agreements outside amnesty programs). The liabilities that are forgiven may include penalties, collection fees, and interest owed on the unpaid liabilities and amnesties may relieve participants from criminal prosecution for their evasion.

“How should the amnesty be designed to avoid discriminating against the honest taxpayer and to avoid giving an unfair advantage to the previous tax cheater? Relieving participants from criminal prosecution and from civil penalties and fees is not a problem – the threat of these provisions is intended to produce taxpayer compliance before the amnesty and that threat has not been successful. Forgiving those consequences doesn’t change the compliance climate and relative treatment of the honest and dishonest.

“But forgiving interest owed on unpaid liability, particularly interest roughly at market levels, does give the cheat an advantage – that taxpayer has been able to use tax owed without paying interest and has therefore had an economic advantage over honest taxpayers. Therefore, providing forgiveness of criminal prosecution and waiving of civil penalties does not violate standards of fair treatment or significantly weaken the incentive for voluntary compliance upon which our tax system depends. That is not so for forgiveness of interest owed on unpaid tax liability—that makes paying taxes a sucker bet. Unfortunately, our amnesty extends to interest owed. Tax cheating really does pay in Indiana—even after amnesty participants have made their payments.

“Third, the Indiana amnesty program permits the Department of Revenue to arrange installment payment programs for amnesty claimants. In other words, the participant does not need to pay all back liabilities in order to receive amnesty, but may enter into an arrangement to make those payments over an extended period into the future. This is not the first state program to provide such an option, but many of the programs do not. The amnesty participants are not, after all, the most trustworthy of risks for the state, inasmuch as they have not complied with the tax law in the past. Any private lender would be reluctant to extend further credit to customers who have stiffed it in the past—and any additional credit would be provided only under toughest terms. Given that payment plans have been permitted in the legislation, one can only hope that the Department of Revenue places the tightest constraints on them.

“Finally, there is a problem in regard to what happens next. Amnesty program collections give a concrete measurement of Department of Revenue futility: These are sums that the revenue department has not been able to collect through its standard enforcement program and it advertises the extent to which tax evasion has been profitable. A successful amnesty program requires some follow-up in terms of greater administrative rigor to at least give the illusion that the cheating that has been successful in the past will not be advantageous in the future. States typically try to change the economics of tax cheating after the amnesty by some combination of greater enforcement vigor (more resources to tax auditing, for instance) and higher penalties for evasion (to make the evasion choice a less attractive gamble). The Indiana amnesty law doubles penalties for any liabilities that would have been eligible for the amnesty (liabilities incurred before July 1, 2004), but liabilities for periods after that would be subject to the same penalties as normally apply. In other words, nothing has changed in the compliance climate! The same environment that produced the considerable sum of uncollected taxes is restored, and it is the same old climate for tax cheating. The question is: Why advertise your failures in tax collection, then do nothing to fix it?

“It’s too late to fix the legislation. How can Indiana make the best of it? It might as well try to collect as much amnesty revenue as it possibly can and evidence from programs in other states shows that an important key is to advertise the program. That means radio, television, newspapers, the Internet . . . every advertising medium is important and not through tedious public service announcements. This is the time for the same advertising approaches that are used to sell erectile dysfunction remedies and beer. The promotion program has to be aggressive and widespread. Even though the opportunity to avoid trouble from the tax collector and save some money at the same time might seem like it would sell itself, that hasn’t proven to be the case. After all, those tax evaders have been successful in avoiding the tax collectors up to now, so they need some convincing about the deal being offered.

“Unfortunately, the Indiana advertisements can’t stress that the amnesty is a last chance opportunity before new and more rigorous enforcement programs go into effect—as many states have used in their amnesties—because such programs haven’t been enacted here, but avoiding penalties and interest still is a good deal for the cheat, particularly when the break applies to liabilities the state already knows about.”

The SPEA toolkit: John Mikesell teaches public finance and policy analysis, specializing in state and local government finance and sales and property taxation.

Click here to read more about Professor Mikesell.