There are compelling reasons to create incentives so that third party opinion suppliers will police taxpayer reporting on matters of factual and legal uncertainty. These reasons ground on a heretofore unnoted effect of making the penalty rate for an under-payment the inverse of the audit rate, which is a widely accepted solution for encouraging compliance. Because of an asymmetry in the treatment of underpayments and overpayments – the former are scaled up by the penalty while the latter, at best, are refunded dollar for dollar – taxpayers have a strong incentive to underpay by a large margin when reporting on matters of factual or legal uncertainty. The effect is quite large at low audit rates and remains significant even at audit rates of 20 to 30%. At low audit rates an inverse penalty collects the right amount on average but it does this not by inducing taxpayers to report fairly, but rather by inducing taxpayers to take aggressive positions and then imposing a large levy on the handful who are audited. This exacerbates the perceived unfairness of a large penalty for non-compliance. It also creates an additional dead-weight burden on transactions that involve legal or factual uncertainty if taxpayers are risk adverse or if the penalty is scaled sufficiently high to suppress aggressive under-payment.

Using a third party to validate a reported item or position is an attractive solution because of what is an agency problem from the taxpayer's perspective. A third party will reap only a fraction of the expected benefit from biased reporting, and so a much smaller penalty can suppress bias at low audit rates. A third party penalty can take the form of a fine that is a small multiple of the deficiency or, even better, indemnity liability to the taxpayer for a penalty paid by the taxpayer that is a small multiple of the deficiency. Third party opinion suppliers are likely to be professionals and repeat players, which makes available other enforcement strategies and sanctions, in particular measures targeting third parties who repeatedly endorse aggressive positions. Of course, third parties could respond by demanding a large share of the benefit from aggressive reporting, which would require a higher third party penalty to suppress aggressive reporting. I argue that this is not an insurmountable problem because the fee becomes an objective signal of the aggressiveness of a taxpayer's position.