It comes as no surprise that people cheat on their taxes. There is a rich literature discussing tax noncompliance, analyzing its causes and discussing ways that the government can deter, detect and if necessary sanction those who would cheat or help others cheat. I too have contributed to the discussion, primarily considering the role that commercial preparers play in decisions to comply with our tax laws in research reports commissioned by the Taxpayer Advocate Service and made part of the National Taxpayer Advocate Reports to Congress in 2007 and 2008.
I and others have been trying to draw on how insights from social science can help IRS and Congress seek to reduce the incidence of cheating on taxes.
Consider the following widely known social scientist experiment that is nicely summarized in an NPR story (the study is from a 1976 article in the Journal of Personality and Social Psychology by Researchers Diener, Fraser, Beaman, & Kelem, called Effects of Deindividuation Variables on Stealing Among Halloween Trick-or-Treaters). Researchers selected a group of children to visit staged homes on Halloween. The experiment involved children, dressed in costumes hiding their identity. The children went trick or treating at 27 different houses, and were greeted by different adults who showed them to a room containing two bowls, one filled with candy, and the other coins. The adults, who were in on the experiment, if asked about the money, told the kids that coins were for a charity and were going to be picked up soon. The adult then left the room. What happened next was that the kids stole. They stole candy. They stole money. They sometimes overturned the bowls and took the whole stash. It didn’t matter if an adult asked a child to act as an anonymous leader to ensure that the kids only took their fair share; the group still robbed the candy and coin bowls. The results changed dramatically if the adults knew the identity of the group of children or even the leader charged to ensure ethical behavior. When anonymity was breached, people stole less. A lot less.
This experiment (and others from social science literature I will discuss in later entries) emphasize that the opportunity to cheat without visibility is a critical factor in a taxpayer’s decision to take a position she knows is either wrong or aggressive enough that if detected the Internal Revenue Service would challenge the position.
The implications of this are far-reaching. Enhanced information reporting is one obvious byproduct, and the research supports the connection between information reporting and tax compliance. The most recent IRS research on the tax gap tells us as much; for items subject to information reporting and no withholding, correct tax reporting is about 92%; for items subject to information reporting and withholding the correct level of tax reporting is about 99%.
It is not just information reporting though that enhances visibility and accountability. Expanding and enhancing due diligence requirements can be effective. In addition, visibility is a crucial underpinning of the IRS’s Return Preparer Strategy that is currently the subject of litigation in the case of Loving v IRS. In Loving, earlier this year, the DC district court invalidated the IRS’s testing and education requirements for previously unlicensed preparers. Prior to implementing Return Preparer Strategy, the IRS literally had no idea who was preparing millions of tax returns. Disparate identification requirements, a lack of a uniform approach to communication, and no meaningful research looking at the way preparers interacted with taxpayers contributed greatly to the sense among preparers and taxpayers using those preparers that they operated in relative anonymity.
I do not want to overstate the point and say that the IRS’s approach to regulating return preparers is a panacea. There will always be unscrupulous preparers. There will be some who are incompetent, and other preparers who turn a blind eye to likely taxpayer lies (more on willful blindness in an upcoming entry). Nonetheless, I believe that the IRS’s approach to the return preparer issue, with uniform identification requirements, reasonable competency testing and ongoing education requirements, will greatly enhance visibility in the return preparation process. It can, with proper implementation, be a valuable tool in the IRS’s arsenal of trying to control errors, especially on returns claiming a refundable credit, which tend to have relatively high error rates and draw an even higher percentage of commercial preparers than other tax returns. IRS needs to understand who is preparing returns; it needs to speak to and correspond with preparers to ensure that preparers cannot hide behind a cloak of invisibility to help facilitate errors or ignore likely taxpayer misstatements. Registration, testing and ongoing education are a useful way to change the dynamics and inject a compliance norm in the multi-billion dollar tax preparation business.
Let’s hope as a policy matter that the Court of Appeals in the DC Circuit reverses the District Court and allows the IRS to continue with its sensible approach to the issue of regulating tax return preparers.