administration. It is my hope that, through the effort IRS began last year and through Congressional efforts, we can begin to develop a framework of general principles or standards for each group of penalties in the Code. With the assistance of practitioner groups, the academic community, and taxpayers, our efforts hold great promise.

My colleagues and I will be happy to respond to questions you and the members of your Subcommittee may have today.

Chairman PICKLE. I want to recognize Dennis Ross, Deputy Assistant Secretary for Tax Policy for the Department of Treasury.

STATEMENT OF DENNIS E. ROSS, DEPUTY ASSISTANT SECRETARY (TAX POLICY), U.S. DEPARTMENT OF THE TREASURY Mr. Ross. Thank you, Mr. Chairman. I, too, appreciate the opportunity to be here and discuss with you today our civil penalty structure and present the views of the Treasury Department on those questions. If the review of this subcommittee can help limit the complexity and improve the fairness of our civil tax penalties, certainly all the taxpayers and the tax system generally will be the beneficiaries.

The subcommittee's hearing comes at a very appropriate time. As you noted, Mr. Chairman, Congress has just completed a fundamental reform of the substantive tax rules, and a comprehensive assessment of the role of tax penalties is a natural second step. In undertaking that assessment, we face a tax penalty structure that has grown very significantly in size, often in piecemeal fashion. It is now a frequent source of taxpayer complaints. At this point in the review process, we can only provide a framework for a analysis since much remains to be done in developing information about how the penalty system and particular penalties work in practice. We look forward, however, to working with this subcommittee during the course of its review, in contributing to the development of any necessary reforms to the civil tax penalty system. Mr. Chairman, to understand the function of civil tax penalties in our system, it is first necessary to have an overall sense of how our collection system works.

Essentially, we collect taxes in three ways: Through voluntary payment of taxes by taxpayers themselves, through withholding by third parties and through collection of taxes by the Service where they are not voluntarily paid or withheld. By far the most important function of civil tax penalties is to encourage voluntary compliance.

The majority of taxpayers recognize the importance of paying taxes and voluntarily accept that responsibility. There remain, however, significant groups who would carelessly disregard the rules or avoid all together their obligation to pay tax. Tax penalties serve to deter such noncompliance. Moreover, the penalties imposed on noncompliance reenforce the honest taxpayers' ordinary instinct to comply, by providing assurance that noncompliance will not be tolerated, and thus, that the burden of taxes is fairly distributed.

Although the tax penalty system's primary function is to act as a deterrent to noncompliance, it must also operate fairly with respect to that great majority of taxpayers who do voluntarily comply. Our system should thus not penalize those who have not behaved wrongfully nor overpenalize those whose compliance is inadvertent. The penalty system must have been designed to minimize administrative difficulties for compliant taxpayers. The penalty system is designed basically to promote both a timely reporting and payment of tax and also the accurate reporting of taxable income. The necessary first step to collecting revenues is to obtain the taxpayer's

statement of the amount due and also the payment of that amount. As you know, there currently are penalties for failure to file a return and failure to pay the amount properly owned. The issues raised by these penalties are fairly straightforward, since it is generally clear when and to what extent they are applicable.

What needs to be considered here is whether these penalties effectively encourage timely reporting and do so in a manner that is basically fair.

Penalties for inaccurate reporting raise a more difficult question. The current penalties for inaccuracies reflect two different basic approaches: One, a traditional tort law concept of fault and the other focusing on the strength of the taxpayer's legal position, without regard to traditional concepts of fault. Historically the fault based civil negligence and fraud penalties bolstered by criminal fraud penalties as necessary, served as the mainstay of tax law enforcement efforts.

As elsewhere in the law, negligence exists where the taxpayer fails the standard of reasonableness; that is, where there is no reasonable basis for the return position. Generally fraud exists where the taxpayer's behavior is clearly wrongful and there is an intentional evasion of tax. These were the only generally applicable penalties to assure taxpayers accurately reported the amount of tax. The second type of penalties grew out of a belief that penalties triggered only by negligent or fraudulent behavior would not adequately assure that taxpayers reported their income accurately. The complexity of the substantive rules has inevitably created large gray areas consisting of arguably correct positions with varying degrees of support.

Standing alone, negligence or fraud standard places relatively little tension on a taxpayer's decision to take an aggressive position in an area of legal or factual uncertainty, since the taxpayer's aggressiveness can often avoid penality in the event of audit and is rewarded if the taxpayer is among the majority of taxpayers not audited.

As a consequence, we now impose penalties on taxpayers found to have taken aggressive positions without substantial legal support. The most significant of such penalties was adopted in the Tax Equity and Fiscal Responsibility Act in 1982, the penality imposed on the portion of an underpayment attributable to a substantial understatement of tax liability.

This penalty is now 25 percent of the portion of any significant understatement not supported by substantial authority or, except in the case of tax shelters, not adequately disclosed on the return. The substantial authority standard effectively requires that the taxpayer have more than a reasonable basis for his return positions, thus placing the taxpayer at risk even though his behavior is not wrongful under traditional standards.

The concerns leading to the substantial understatement penalty have been especially pronounced in the tax shelter area. This has led to a number of penalties dealing with taxpayers participation in tax shelters and similar transactions. Thus, the substantial understatement penalty applies on a more stringent basis to certain tax shelter items reported by a taxpayer with a principal purpose of avoiding paying tax.

A substantial undervaluation penalty applies to individuals and certain corporations underpaying taxes due to the use of an inflated value or tax basis for property. There is a new civil penalty which applies to any underpayment attributable to tax motivated transactions.

Mr. Chairman, although we are focusing on the civil penalties applicable to taxpayers today, it should not be forgotten that many of the civil tax penalties apply to obligations unrelated to a taxpayer's own tax liability. These penalties are in fact a source of many complaints we hear about the penalty system.

Because withholding is a critical part of the collection system, failure to withhold on a timely basis is subject to penalty. Similarly, information reporting has come to play an increasingly important role in tax compliance, and penalties have been established for a failure to file an information return, a failure to provide a copy of such return to the taxpayer and a failure to provide correct information on a properly filed return.

A number of penalties buttress those imposed on nontaxpayers— I should say, on the taxpayer, for a failure to report accurately. Thus return preparers are penalized for negligence or intentional understatement of a taxpayer's liability. There is a civil penalty for aiding and abetting the understatement of tax.

A number of nontaxpayer penalties focus on those who market and promote tax shelters: Failing to register an investment deemed to be a tax shelter, and failing to maintain an investor list respecting a tax shelter.

Mr. Chairman, having identified in general terms the role for penalties, and the most significant of the current existing civil tax penalties, let me suggest a number of the issues that should be addressed during the course of your subcommittee's review.

Examination of the civil penalty system should begin with its increasingly complex legal structure. Such complexity is itself a matter of concern. Penalties will not be effective unless understandable by taxpayers and the IRS personnel responsible for asserting them. The interrelationship of the various penalties must also be examined with a view to eliminating gaps in coverage or penalties that inappropriately overlap.

There are, for example, several different penalties potentially applicable to the taxpayer for participation in a single tax shelter transaction, which may overpenalize such behavior. In this regard, it would be appropriate to examine the severity of individual penalties and to consider whether first-time offenders should be treated more leniently than others.

Reviewing the civil penalty system must focus on the manner in which penalties are being administered. There specific issues appear to merit particular attention: First, is whether the computerized assertion of certain penalties result in an unfair burden on persons against whom no penalty is ultimately assessed.

Second, whether the assertion of overlapping penalties and large penalties has in practice distorted the administrative procedures designed to resolve disputes between taxpayers and the IRS, because such penalties inevitably become part of the tax revenue at stake in such disputes. Finally, there is a question of whether the

understatement penalty in practice penalizes taxpayers who have made errors merely that are inadvertent.

Finally, Mr. Chairman, in reviewing the civil penalties system we need to keep in mind that penalties are but one of a number of administrative tools that promote compliance. Thus, the taxpayer assistance programs and the public forms, regulations and rulings can all promote accuracy and encourage or reenforce positive efforts by taxpayers to abide by the laws.

Such instruments are particularly important in times when substantive changes force taxpayers to reassess their conduct for the future. In conclusion, let me say that we look forward to working with this subcommittee, with the IRS and others in seeking to find answers to the questions raised by our existing civil penalty system.

Thank you.

[The statement of Mr. Ross follows:]