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Winning the Audit Lottery—A Commentary by Ian Ayres ’86 and Barry Nalebuff

The following commentary was published in Forbes on November 12, 2009.

Winning the Audit Lottery
By Ian Ayres ’86 and Barry Nalebuff

The chance your tax return will be audited is 2 in 1,000--and we think that's far too low. Really. In 2008 the average field exam of an individual return generated $19,000 in additional taxes. Even if incremental audits were only half as productive, doubling the rate would bring in another $3 billion in revenue. Higher audit rates would also indirectly generate revenue by motivating taxpayers to be more honest. Lots more honest. Jeff Dubin at Caltech estimates that an additional dollar directed toward audits would return $58 through higher compliance.

To make matters worse, we're relying on outdated data in deciding whom to audit. Every three years until 1988 the IRS randomly selected 100,000 returns for nasty, intrusive reviews, the purpose being not so much to squeeze every last penny from those unfortunates as to find out where the chiseling was going on. These extreme audits provided the IRS with statistical profiles of noncompliance that formed the basis for the agency's formulas used to target returns with the highest chance of underreporting.

The problem was that extreme audits were an unfair burden for those who were selected. These audits took twice as long as the usual ones. Anti-IRS pressure mounted, and the superaudit was fIRSt delayed and then canceled in 1995. The program has been replaced with a smaller and less-data-intensive program that imposes fewer costs on taxpayers but produces much less useful compliance information.

Society would probably be better off with double the number of audits, but no one wants to have his or her number called. What is to be done?

Pay people for being audited--say, $3,000 for the extreme audit. Stanford tax guru Joseph Bankman notes that this sum would overcompensate almost all taxpayers; someone getting that much for 40 hours of trouble would be getting $75 an hour. To be sure, the richest taxpayers and people with the most complicated returns would be only partially compensated, and the money wouldn't necessarily cover the fee of a tax attorney or accountant. But $3,000 of compensation would go a long way in reducing the public opposition to auditing.

The cost of an audit is just the kind of risk that government should insure. Tax preparation firms already offer this kind of insurance. For $30 H&R Block sells you a policy that sends an H&R agent to represent you if you are audited. TurboTax's Tax Resources service (about $300) promises, "You will never meet with the IRS."

The higher direct and indirect revenue from additional audits should more than cover the costs of compensation--especially if compensation is made conditional on getting a sufficiently clean slate of health. We might initially reduce the compensation by $1,000 for every $1,000 or 1% (whichever is bigger) of unpaid tax uncovered.

Audit compensation is not just about fairness. The big hope is to end the stranglehold that anti-IRS forces have on compliance efforts. A central idea behind the Constitution's takings clause is to reduce government's inclination to take too much. A government that is forced to compensate for the exercise of its eminent domain power is less likely to engage in value-reducing land grabs.

Absent compensation, Congress has vetoed efficient audit programs--setting the audit rates far below their optimal level. Here's a rare case where forcing the government to pay for something is likely to increase its demand.

Arizona's Lengthy Trial Fund pays those chosen at random to serve on a jury up to $300 per day for longer trials. And, back when we had a draft, until 1973, the military compensated people who were drafted at random. No less should hold true for people who at random are asked to serve the IRS. Indeed, compensation could play an important role in rebranding audit participation as a patriotic service to our country.

People might even start to see filing their taxes as indirectly buying a lottery ticket with a chance to win $3,000. (Indeed, we could give them a special lottery ticket.) Instead of groaning when you receive your letter announcing that you are going to be audited, you might react: "Hey, I won the lottery."

Ian Ayres and Barry Nalebuff are professors at Yale Law School and Yale School of Management. Ayresí latest book, Super Crunchers, was published in August. Visit their homepage at forbes.com/whynot.