An earlier version of the following post appeared on the Forbes Procedurally Taxing site on December 1, 2014
Last month, William Cobb, the President and CEO of H&R Block, wrote to the Commissioner asking that the IRS implement changes to tax forms to make it more difficult for taxpayers to prepare their own returns claiming the earned income tax credit (EITC). The cynical response to this is that Cobb wants more taxpayers to come to the paid preparer behemoth. After all, Cobb’s main role is to increase profitability for the company. Yet, as I explain here, I think the changes he proposes would likely be good for the tax system because they could enhance visibility and accountability, principles the IRS should emphasize with issues that tend to have sticky error rates.
While I am not necessarily saying that what is good for H&R Block is good for the tax system (apologies to GM’s “Engine” Charlie Wilson who was reported to have said that “what is good for GM is good for the country”, though some claim he was misquoted), changes that enhance visibility and accountability are the most effective and cost-efficient ways of decreasing errors. If the changes happen to be good for Block and other paid preparers so be it. Maybe it is time to explicitly recognize that the IRS sometimes needs the help of the private sector to do what Congress tasks (but not necessarily funds) it to do, especially when the private sector’s interests may align with the government’s interest in reducing the incidence of misreporting credit eligibility.
As most readers know, the EITC is and has been for some time one of the principal ways the federal government incentivizes lower-wage work and reduces poverty, especially among children. Its administrative costs are relatively low, and the credit has generally received bipartisan support. Despite the EITC’s success, its error rates have drawn attention from those who criticize the credit (or wish to discredit the IRS or transfer programs generally; more on EITC errors and reasons for bashing IRS for its EITC administration in an earlier post EITC: Do Attitudes on Redistribution Fuel a Particular Focus on Errors). Despite the criticism, the EITC error rate is relatively low compared to other segments of the tax gap, such as small business underreporting of income (which costs the fisc way more than misclaimed EITC), and I suspect that many of the EITC errors are more in the way of foot faults with a wrong parent or relative claiming a child whom the relative has some connection with. Alternatively, in some instances what is reported as an EITC error may in fact be the result of correspondence audits that taxpayers are ill-equipped to meaningfully engage even when the claimed credit was proper (To that end see a 2010 article by former clinician Kate Leifeld in the Maine Law Review discussing a 2007 Taxpayer Advocate Service study on the impact of representation on low-income taxpayers subject to audit).
To be sure, even if the reported EITC error rate overstates the extent of the problem, the sheer size of the EITC program and the deep-rooted American antipathy to undeserving handouts (think of the image of Reagan assailing the mythical Cadillac welfare mom), means that EITC errors generate headlines and efforts to reduce the extent of improper EITC payments. For example, the IRS’s ill-fated efforts to regulate unlicensed preparers through a mandatory education and testing program stems in part from former Commissioner Shulman’s efforts to tackle refundable credit compliance problems. In addition, in the past few years, Congress, Treasury and IRS have all combined to make the special EITC due diligence rules have more bite. (I have written about those changes here in IRS Leaves Hundreds of Millions of Dollars in Preparer Penalties on the Table). The due diligence regime now includes stiffened penalties of $500 per infraction, regulations filling in details on the extent of preparer obligations (including requiring preparers to submit a due diligence form with a tax return and retain documents the preparer relied on to determine eligibility) and fairly extensive and at times intrusive due diligence audits that can result in many thousands of dollars in liabilities for what some might think of as minor mistakes such as failing to keep a document the preparer purported to rely on for determining eligibility. Cobb in this letter and in past statements links the recent decline in reported paid preparer returns from a high of about 72% in 2008 to close to 62% in 2012 on the expanded due diligence rules.
Rather than ask for rolling back the due diligence rules, Cobb asks that the IRS level the playing field:
H&R Block has and continues to support due diligence standards for paid preparers. However, the IRS will see immediate benefits if it seizes the opportunity to require all EITC taxpayers, including the more than 40% of taxpayers who self-prepare their returns, to submit additional eligibility information to the IRS: the IRS would have better information more quickly on the sources and causes of improper payments, and it will likely see a reduction in the improper payment rate.
Cobb implores that the IRS modify the Schedule EIC taxpayers submit with their returns, presumably to align with some of the IRS’s most recent compliance study on the EITC, which shows both that self-prepared EITC returns have a higher error rate (28-39%, low to high estimates) than national chain commercial preparers (20 to 30%), that unenrolled preparers (33 to 40%) have a significantly higher error rate than licensed and national chain preparers, and that misstating residence of children continues to be the largest source of EITC errors by dollars (Note: I have written this past September on that EITC compliance study in IRS Issues New Report on EITC Overclaims (Title A); that study is from 2006-08 returns and predates the drop in reported paid preparer usage which began in 2009, which I also wrote about in EITC Snapshot: Overclaims and Commercial Preparer Usage).
Impact of Cobb’s Proposal and What Research on Lying Tells Us
Would Cobb’s proposal be good for Block? Of course. Placing more obstacles in the way of self-preparing returns makes it more likely that taxpayers will seek assistance from someone else. VITA and TCE (Tax Counseling for the Elderly) free return prep programs only prepare a small % of EITC returns (though a recent IRS EITC compliance study shows volunteer-prepared EITC returns with very low error rates in the range of 11 to 13%). With increased regulation in the form of the due diligence rules and the IRS’s voluntary paid preparer testing and education plan announced last year, it seems that the number of smaller paid preparers will likely decline. This benefits the larger chains, which train their employees and can take advantage of their size to defray costs.
Would his proposal also be good for the tax system? While there is a cottage industry among social scientists studying the reasons for tax compliance (and honesty and compliance generally), accountability and visibility (backstopped by sanctions) are main drivers for following rules. This is especially true for rules that while somewhat complex are not legally ambiguous, such as the EITC. Professor Dan Ariely details the power of visibility and accountability (and even perceived visibility and accountability) in his accessible and entertaining 2012 book The (Honest) Truth About Dishonesty. While the book is not freely available (though this animated lecture on the book is terrific and linked at Brain Pickings) an article by Maria Konnikova in New Yorker last year called Inside the Cheater’s Mind nicely summarizes some of the research Ariely discusses in his book. That research suggests that environmental changes that enhance a person’s perception of anonymity will lead to increased dishonesty:
Most modern research on cheating explores the subtle behavioral influences that form the noisy background to our daily choices. In a typical laboratory set-up to measure cheating behavior, people are placed in a situation where they think their actions are anonymous and where there is no chance of getting caught. In reality, of course, what they do is observed. As it turns out, almost anyone will cheat when given even minor, consciously imperceptible behavioral cues. For instance, in a series of three experiments, a group of psychologists found that lighting could affect cheating. In one study, participants in a dimly-lit room cheated more often than those in a lighter one. While both groups performed equally well on a set of math problems, students in the darker room self-reported that they correctly solved, on average, four more problems than the other group—earning $1.85 more as a result, since they were being paid for each correct answer. The authors suggested that the darkness created an “illusory anonymity”: even though you aren’t actually more anonymous in the dark than in the light, you feel as though you are, making you more likely to engage in behaviors you otherwise wouldn’t.
Konnikova also discusses how research suggests there are ways to enhance visibility, which contributes to less dishonesty.
Fortunately, the same is true for preventing cheating: small shifts in the environment that seem unrelated to honesty but trigger self-reflection can make people less likely to cheat. If we know we’re being watched, for instance, we become less likely to behave dishonestly. Even subtle signs of surveillence are persuasive: mirrors or pictures of eyes can dissuade cheating. In one study, people contributed three times more money to a coffee-payment honesty box when they were under a poster of eyes, as opposed to one of flowers.
To be sure, merely requiring people to prepare a tax return with a prominent honesty pledge or a pair of eyes will not bring down error rates to zero. There will always be some drawn to game the system just as there will be those who behave honestly no matter the environmental factors. In fact Ariely suggests about a 15% or so error rate is reasonably acceptable. Yet measures such as enhanced taxpayer disclosure of information can make it more uncomfortable for people to behave improperly and nudge those who might be on the fence as to whether they should cheat on their tax return.
As Ariely discusses (and the Brain Pickings lecture highlights), people want to view themselves as good and honest people, but if they can do the wrong thing without too much psychological cost (such as exposure), well, then people will often do the wrong thing. Moreover, Ariely contrasts how certain circumstances lend themselves to rationalization for stealing (e.g., downloading music) from other situations where it is much more difficult to steal without viewing yourself as a bad person (leaving a restaurant without paying).
The tax system is much closer to the music industry than the restaurant business. To combat that circumstantial impediment, tax administrators should more explicitly recognize the duality and highlight ways to ensure that the psychological costs are greater to misstate eligibility on a tax return. In issues where there are strong indications of systemic noncompliance, or other issues where political sensitivity to errors is disproportionate to the actual costs to the system (such as the EITC), taking measures that will smoke out facts that are tied to the specific sources of errors will likely drive down noncompliance, especially if the other variables on a particular issue are already visible to the IRS. In the case of the EITC, the main variables for eligibility are income and a family member’s residence. Much though not all income is subject to information reporting. Residence of children is not; while we do not want IRS employees poking into bedrooms to see if Junior is in fact living with Uncle Tony, making Uncle Tony for example list the months and addresses when Junior supposedly spent more than six months in the same house as Tony on a self-prepared return is not overly burdensome, and enhances the visibility that research suggests will drive more honest behavior.
For those who say that the information Uncle Tony would have to disclose is too intrusive, well taxpayers have the option of foregoing benefits if they do not want to share their personal information. In addition, Congress and IRS are asking preparers in the form of due diligence rules to ask taxpayers probing questions and disclose to the government how they know a taxpayer is eligible to treat a child as a qualifying child (and retain documents to prove that). Failing to up the ante on self-prepared returns will drive taxpayers who want to stay in the shade away from preparers or to preparers who are willing to flout the rules. That cannot be what the IRS wants.
In sum, Block CEO Cobb’s recommendation to enhance information taxpayers disclose on Schedule EIC for self-prepared returns is good for tax administration and if happens to be good for Block well maybe that is not so bad, as the IRS can use whatever help it can get. Anyway, the private sector may be a better partner than Congress these days.
Update: For a response to this post from Intuit’s Chief Tax Office David Williams, see here.