TEI opposes Virginia legislation to permit contingency fee audits.

On January 31, 1996, Tax Executives Institute filed the following comments with the Virginia legislature opposing proposed legislation to permit localities to hire accounting firms to conduct audits of local taxes. TEI's comments were prepared under the aegis of its State and Local Tax Committee whose chair is Christopher W. Baldwin of Gannett Co., Inc.

As President of Tax Executives Institute, I am writing to express the Institute's policy objections to House Bill No. 768, which would authorize localities to hire accounting firms to conduct audits of local taxes. TEI has fundamental concerns about such a proposal, which we believe would seriously undermine the integrity of, and public confidence in, local tax administration.

Background

Tax Executives Institute is a volunteer, professional association of nearly 5,000 accountants, lawyers, and other professionals who are responsible for managing the tax affairs of their companies. TEI members must contend daily with the interpretation, application, and enforcement of business tax laws. We represent a cross-section of the business community - in Virginia and across North America - and are dedicated to the development and effective implementation of sound tax policy. We are similarly committed to the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. TEI believes that the diversity, training, and experience of its members enable it to bring a unique and balanced perspective to the policy issues raised by House Bill No. 768.

Discussion

House Bill No. 768 would amend the Code of Virginia by adding section 58.1-3902.1, relating to the use of professional accounting firms for performing audits of local taxes. Specifically, the legislation would authorize the commissioner of the revenue or director of finance for any county or city, or the tax-assessing officer of any town, to "employ, upon such terms as may be agreed upon, the services of professional accounting firms to assist with the audit of any local taxes." Hence, the bill would authorize the hiring of contract auditors on a contingency fee basis.

Tax Executives Institute strongly objects to the proposed legislation. We believe the use of so-called bounty hunters by local jurisdictions in Virginia could deprive taxpayers of due process and significantly undermine the public's perception of the tax system's fairness. We also believe that the determination of tax liability is a core governmental function - similar to the provision of police protection - that the legislature should be loath to outsource.

At first blush, the privatization of the government's audit function is appealing. The use of contract auditors seems to provide localities a way to secure revenues without spending a cent. Like other concepts that seem too good to be true, however, the use of contract auditors is fraught with risk and the potential for significant adverse consequences. Stated bluntly, the proffered justifications for contract, or contingency fee, audits are specious and the policy objections to them are overwhelming. Indeed, we submit that contingency fee audits are more inimical to the tax system's fairness than the use of quotas, which have been roundly and rightly condemned (and uniformly disavowed by Virginia and other States).

Contract audits violate public policy. They threaten taxpayer privacy and, where the auditor is paid on a contingency basis, deprive taxpayers of due process and subject them to abuse. No longer would a taxpayer's liability be determined by a public employee, but by a "bounty hunter" whose compensation is directly linked to the amount he or she can extract from the taxpayer. Contract auditors would gain access to the most important personal, financial, market, and customer data that businesses and other taxpayers possess. Since contract auditors at best would be providing their services to a locality on a part-time basis, they would be in a perpetual conflict of interest vis-a-vis their private clients. What safeguards would be - could be - imposed to prevent the unauthorized use or disclosure of taxpayer information - not only during the contract period but after it ends? What restrictions would be placed on where taxpayer information is stored or who at the contractor's firm would have access to it? What type of sanctions would be imposed for unauthorized use? Could damages for unauthorized use be sought from both the locality and the contract auditor?

These questions underscore the difficulty of outsourcing core government functions to the private sector. They demonstrate the problems inherent in asking contract auditors to attempt to serve two masters - the locality and their private clients. They make it impossible to believe that the public at large would support or benefit from this proposal.

The use of contract auditors has justifiably come under attack in the courts. The seminal case in this area was decided by the Supreme Court of Georgia in 1991. In that case, the court quickly dispatched a contract audit fee scheme whereby an outside firm would audit property tax returns and receive 35 percent of any additional amount collected plus 100 percent of all first-year penalties collected. The court upheld Sears, Roebuck & Co.'s challenge to the system, stating:

The people's entitlement to fair and impartial tax assessments lies at the heart of our system. Fairness and impartiality are threatened when a private organization has a financial stake in the amount of tax collected as a result of the assessment it recommends.

TEI believes that it is wholly proper to focus on the deleterious effect that contract audit arrangements can have on the impartiality and fairness of state tax systems. Like the Justice of the Peace who gets to keep a percentage of the speeding fines he imposes, contract auditors who are compensated on a contingency fee basis will not be perceived as objective. This view is shared by the Federation of Tax Administrators (FTA), which is an association of tax administrators from across the United States. The FTA has stated that contract audit arrangements "are not healthy for the tax system." The FTA has also observed that contract audits "introduce extraneous issues such as motive, work habits, and the like into the audit situation - all of which detract from the goal of objectively determining the appropriate amount of tax due."

TEI appreciates that localities are under tremendous pressure to reduce costs and increase the revenues flowing to their coffers. The urge to "privatize" the audit function may seem irresistible. We sincerely believe, however, that contract audits are nothing but fools' gold.

Conclusion

For the foregoing reasons, Tax Executives Institute urges the legislature to resist the hollow promise of contract audits and to reject House Bill No. 768.

If you should have any questions about the Institute's comments, please do not hesitate to contact Christopher W. Baldwin of the Gannett Co. in Arlington, who is chair of TEI's State and Local Tax Committee, or Timothy J. McCormally of the Institute's professional staff in Washington, D.C. Mr. Baldwin's telephone number is [phone], and Mr. McCormally may be reached at [phone].