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What Kids Peeing in the Pool Can Teach Us About Tax Compliance

Posted on Feb. 4, 2014

The tax-filing season is here. All across the great land, people are logging in to Turbo Tax, asking their accountant Uncle Fred to do their return for free, or visiting the enrolled agent who like NFL coaches tells their families that during the season they will not be around much til the season ends.

The start of tax season also coincides with Groundhog Day. Phil popped out this past weekend, and while he forecasts six more weeks of winter, I am today thinking about pools and their unlikely connection to tax compliance and tax return preparers. Consider the story from a couple of years ago involving Ryan Lochte and Michael Phelps. Former Olympic teammates and sometime rivals Lochte (who made news last year and possible tax exams everywhere with a TMZ report of a $600 tip at a steakhouse in Vegas) and Phelps made quite a stir when they admitted that they occasionally urinate in the swimming pool while waiting around before races.  What does the reaction to this story tell us about tax compliance? Well, it connects to the concept of willful blindness and tax return preparers and one of my favorite academics, Dan Ariely, who has written extensively on rationality and why people lie and cheat.

The major health risk associated with pools is drowning. I know a bit about this because my lovely wife Valinda chaired our local club’s pool committee.  CDC stats on drowning are startling:

  1. From 2005-2009, there were an average of 3,533 fatal unintentional drownings (non-boating related) annually in the United States — about ten deaths per day. An additional 347 people died each year from drowning in boating-related incidents:
  2. Children ages 1 to 4 have the highest drowning rates. In 2009, among children 1 to 4 years old who died from an unintentional injury, more than 30% died from drowning.
  3. Drowning is responsible for more deaths among children 1-4 than any other cause except congenital anomalies (birth defects).
  4. About one in five people who die from drowning are children 14 and younger.
  5. For every child who dies from drowning, another five receive emergency department care for nonfatal submersion injuries.

Ok, back to tax compliance. While not nearly as serious a problem as drowning, people using the pool as a public urinal is a problem, or at least a perceived problem. While scientists confirm that generally the presence of urine in the pool poses little health danger, the science does not alter our revulsion at the prospect of someone pulling down their trunks and whizzing in the deep end.

Professor Ariely offers more on the topic (for his blog post on this see here; my title to this post is a direct borrow from his post which was about willful blindness and the public’s view of Jamie Dimon and JP Morgan Chase):

Many of us have spent time beside a pool. And you have probably wondered: what are the odds that no children (or adults, for that matter) have peed in the water? When pressed, we’d have to admit that the odds that the pool is pee-free are close to zero, but the lack of absolute certainty allows us to relax and swim anyway. We may comfort ourselves with some fuzzy thought about chlorine, or the immense volume of the pool relative to a few bladders, and our concerns slip away.

Now, compare this with watching a kid stand by the pool and pee into it. Throw in some swimming trunks around his knees and a frantic, embarrassed parent scooping him up, alas, too late. Now you’re no longer able to hold on to the slight possibility that the pool is free of urine. The relative volume of the water in the pool is now little comfort when you just saw a kid pee in it. Could you still take a quick dip?

Well, for readers still with me, this squeamish guy would act just as Spaulding did when the Baby Ruth floated by in Bushwick Country Club’s swimming pool in Caddyshack: “Doodie!!!!” (for that classic scene click here—that never gets old).

So how does this connect to tax compliance? I think that some return preparers put their blinders on when it comes to information that their clients tell them. Generally, in our tax system current rules emphasize that preparers have duties of further inquiry only in relation to specific information about a particular taxpayer. If, for example, the preparer has reason to believe the information is false, the preparer must ask further questions. For some preparers, if forced to see reality (e.g., that a client in fact is not sharing information on cash receipts), the psychological costs of preparing that return and turning a blind eye to the taxpayer’s gaming of the system will increase. Moreover, by being asked direct questions, the taxpayer’s own psychological costs for cheating will also increase.

To be sure, there will always be dishonest taxpayers and preparers who will disregard those costs and do the wrong thing, but as Ariely and others point out these psychological costs make a difference for the vast majority of people who decide in certain situations whether to be truthful.

There is one major exception to the rule that preparers do not have targeted due diligence obligations. As I have previously written in a post, the only specific preparer due diligence rules in the Code relate to EITC. The recent discussion draft on tax administration reform that Senator Baucus floated (summarized briefly here) would expand the due diligence rules to the child tax credit. What about other areas of systemic noncompliance, like the underreporting of income by self-employed taxpayers, which is responsible for the major part of the underreporting tax gap, well in excess of the gap from every refundable credit combined?

Back in 2008, when I wrote a research report for TAS on tax return preparers, I specifically proposed that IRS and Congress tighten up the EITC due diligence rules but also consider expanding those rules to other areas:

[t]he current rules [on due diligence] emphasize that preparers have duties of further inquiry only in relation to specific information about a particular taxpayer. If, for example, the preparer has reason to believe the information is false, the preparer must ask further questions. I propose that Congress and the IRS heighten the preparer’s responsibilities in response to research that suggests there is systemic noncompliance with specific issues. Their doing so will reflect a more nimble approach to tax compliance, allow for tailored responsibilities that tie to specific systemic issues, and increase taxpayer and practitioner visibility and responsibility for presenting correct factual information on tax returns.

Congress and IRS have tightened up the EITC due diligence rules. Why not due diligence for other issues? The asking of direct questions by preparers would likely increase the psychological costs for individuals who might  cheat on the returns but might have been inclined to tell incomplete or inaccurate information to the preparer. It is the same type of idea that animated a recent proposal by Joe Bankman of Stanford and others when they proposed creating a smart return that would use technology and adaptive questioning to increase the psychological costs of taxpayers themselves lying on a tax return.

Parting Thoughts

For those serious about tax administration, and not just those whose focus on EITC overclaims masks a hidden agenda that reflects an undue bias on one aspect of the tax compliance problem, it is time to raise the psychological costs of cheating in other parts of the tax system. Targeted due diligence rules that direct preparer attention to specific issues that tend to have high error rates (like unreported small business income) will foster increased accountability and visibility and likely reduce the underreporting tax gap.

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