Today we are at the ABA Tax Section May Meeting soaking up some insights that we hope to share with readers. In the meantime, rather than go dark, we are reposting a piece from February 2014. The post highlights how individual tax returns tend to be incorrect when there is an opportunity for either the taxpayer or the preparer to turn away from the facts. Recent tax gap data confirms that compliance follows information reporting, so when individuals know that payers report income not surprisingly they tend to file more accurate returns. Not all tax returns are accompanied by third party information, with small business taxpayers earning much income not subject to reporting and some family status benefit provisions like the EITC and CTC dependent in part on variables like residence of kids which are outside the information reporting regime.
While sweeping in Caddyshack, Groundhog Day, the brilliant Dan Ariely and my wife, the post discusses how it is easy psychologically to avoid reality. It suggests that the tax system should perhaps force preparers to face the facts in the form of expanded due diligence when issues are not easily backstopped by information reporting. The piece perhaps has more relevance today, as in late 2015 Congress expanded the due diligence rules to cover CTC and the American Opportunity Tax Credit. The expansion raises questions as to what role preparers play in the tax system, with some suggesting that the proposals push the preparer toward auditing their client. Moreover, there has been a steady decline in use of paid preparers for the EITC, suggesting perhaps that the added costs that preparers pass on to their clients have contributed either to a shift to DIY returns or ghost returns that preparers fail to sign to avoid possible liability. Les
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.
read more...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:
- 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:
- 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.
- Drowning is responsible for more deaths among children 1-4 than any other cause except congenital anomalies (birth defects).
- About one in five people who die from drowning are children 14 and younger.
- 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.
About Leslie Book
I love Ariely’s work and own well-worn copies of all of his books. Behavioral economics is an eye-opening field.
I understand why you’d want to use Dan’s pool example, however I’m not sure it applies here. One of the interesting facets of many of Dan’s studies is our irrational individual behavior while in groups. Whether it’s poolside or in a classroom, group settings influence behavior.
Ordinarily, you might not care that you saw a child pee in the pool. Such insight might not influence your behavior. However, concerns about what others *might* think of you for entering the pool now that you’re all aware of the same information….that is what truly keeps many from doing what they might otherwise have done while alone.
The presence of your personal tax preparer simply isn’t the same degree of influence.
I will say that Dan offers suggestions about how to influence behavior in group settings. Something as simple as an honesty oath prior to test taking appears to have some influence over cheating. Perhaps reciting an honesty pledge to fellow Americans might have a similar impact.
Thanks Joe for your thoughts. I wonder though if your revulsion at swimming would differ even if only you saw the child and there was no one else there. It still may be a bit too attenuated to connect this part of Ariel’s research to tax but I take it in part as suggesting that we tend to suspend what we know if we can avoid looking or confronting the truth. I think the due diligence rules are meant in part to heighten the psychological and real costs for turning away from facts that preparers ought to know and claimants in fact do know.
It’s definitely safe to say that we wouldn’t all respond in the same manner. I do believe some (perhaps even many) of us might be affected even if others aren’t present.
To your point about confronting the truth, consider what happens in the “privacy” of our automobiles as we commute. Oftentimes, when drivers do (or are in the process of doing) something they shouldn’t, they avoid eye contact with anyone outside of the vehicle. We know they’re wrong. They know they’re wrong. But only on the rarest of occasions will the driver make eye contact. Merely seeing the reactions of others around us make it painfully obvious that we’ve done something wrong, perhaps even illegal. So we avoid eye contact as if to assure ourselves that we’ve done nothing wrong.
I wonder if a carrot rather than a stick may be a better approach. Some research suggests that penalties, unless they’re quite severe, are rarely a deterrent…particularly if the benefits of continuing a behavior outweigh the penalties. The challenge is structuring an incentive that would improve the outcomes.
https://www.irs.gov/pub/irs-pdf/pcir230.pdf –
US Treasury Circular 230 governing all tax practitioners addresses this concern for all entries on submitted tax forms as follows below. The question I have is … why is there no teeth to this regulation? Why are we incapable of simply enforcing the rules that we have in place at present?
§ 10.22 Diligence as to accuracy. (a) In general. A practitioner must exercise due diligence — (1) In preparing or assisting in the preparation of, approving, and filing tax returns, documents, affidavits, and other papers relating to Internal Revenue Service matters; (2) In determining the correctness of oral or written representations made by the practitioner to the Department of the Treasury; and (3) In determining the correctness of oral or written representations made by the practitioner to clients with reference to any matter administered by the Internal Revenue Service.