Who's Naughty and Who's Nice? Frictions, Screening, and Tax Law Design

Abstract

This Article sets forth a new dimension for designing and evaluating the tax law. Scholars have examined how many provisions throughout the tax code serve as “frictions” on tax planning, by imposing costs as a means to deter such planning. In this Article, I argue that, by imposing costs that will necessarily be borne differently by different taxpayers, frictions also inherently screen between different taxpayers. Recognizing how frictions screen upends conventional wisdom regarding the design of tax law. By focusing on the deterrence aspect of frictions, and not recognizing their additional screening role, scholars have concluded that: (1) frictions are successful if they deter tax planning rather than cause it to continue in a more wasteful fashion, and (2) that frictions should not impose costs on regular, business transactions. However, in coming to these conclusions, scholars have missed the key inquiry regarding frictions. As I flesh out in this Article, the key inquiry should be whether frictions impose differential, and greater, costs on tax planners, relative to non-planners, and thereby reduce the overall social cost attributable to tax planning. This inquiry not only reveals that frictions that successfully deter tax planning may nonetheless fail as a result of poor screening, but also that imposing costs on regular, business transactions is not always a flaw of a friction. More broadly, this inquiry suggests a new, more robust framework for optimal tax law design, which incorporates screening as a central part of the analysis. Many times frictions impose higher costs on taxpayers based on characteristics other than tax planning motivation. At times, these unintended screening results are undesirable, but not overly problematic, and they may even be remedied by careful attention to screening. Other times, however, these screening results are perverse, and counsel reform or elimination of the friction altogether. In any event, understanding how frictions screen is essential to ensure that the right taxpayers are bearing the right costs throughout the tax code, or, alternatively, that important deterrence objectives justify any undesirable screening outcomes.