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of experts in legal compliance. Tax practitioners possess the means to exert an extraordinary influence on the tax compliance process. Their knowledge of tax ...
Journal

of Public

Economics

52 (1993)

163-197.

North-Holland

Taxation

with representation

An analysis compliance

of the role of tax practitioners

in tax

Brian Erard* Department of Economics, Carleton University, Ottawa, Ontario KIS 5B6, Canada Received November

1990, final version received

September

1992

In this paper a framework is developed for the joint analysis of tax preparation mode and tax non-compliance. Estimation is performed using micro-level audit data from the Internal Revenue Service. Although the availability of tax practitioners undoubtedly reduces many of the informational and computational barriers to tax compliance, the results indicate that their use, particularly the use of CPAs and attorneys, is associated with increased tax non-compliance, which may have negative implications for both tax equity and tax efficiency.

1. Introduction In response to complex social rules and obligations, individuals often find it advantageous to seek assistance from experts. Experts may facilitate compliance with social rules and obligations by reducing their clients’ legal uncertainties and by lowering the time and anxiety costs associated with compliance. Alternatively, they may assist their clients in devising strategies to exploit legal ambiguities in order to avoid compliance with costly rules and regulations. The tax system provides a rich setting for examining the role of experts in legal compliance. Tax practitioners possess the means to exert an extraordinary influence on the tax compliance process. Their knowledge of tax rules and enforcement procedures far exceeds that of ordinary taxpayers, and they are directly responsible for preparing nearly one-half of all individual returns. Moreover, Correspondence to: B. Erard, Department of Economics, 1125 Colonel By Drive, Carleton University, Ottawa, Ontario KlS 5B6, Canada. *This paper is based on research that I performed while I was employed by the Internal Revenue Service. Some earlier drafts were circulated under the title, ‘An Endogenous Switching Analysis of Tax Preparation Mode and Tax Compliance’. I am grateful to Jonathan Feinsteinr Richard Helleloid, Jan Kmenta, JeN MacKie-Mason, Joel Slemrod, and two anonymous referees for helpful comments and suggestions. I also wish to thank the Internal Revenue Service, particularly Dennis Cox and the other members of IRS Compliance Analysis group, for providing me with the support necessary to perform this analysis. The views expressed in this paper are my own; they should not be attributed to the Internal Revenue Service. 0047-2727/93/$06.00

0

1993-Elsevier

Science Publishers

B.V. All rights reserved

164

B. Erard, Taxation

with representation

compared with self-prepared returns, returns prepared with paid assistance are more likely to involve complex issues with substantial revenue consequences. In a recent study, Blumenthal and Slemrod (1992) estimate that the total resource costs of taxpayers in complying with the 1989 U.S. personal income tax laws averaged $3.54 per taxpayer, or approximately $39 billion in aggregate.’ Although this amount is already quite substantial, representing over 7 percent of federal and state income tax revenue, the amount undoubtedly would have been much larger in the absence of tax preparer services. Yet, while tax practitioners alleviate many of the informational and computational barriers to tax compliance, they also possess the expertise to assist their clients in exploiting opportunities for tax non-compliance. The promotion of non-compliance opportunities can have important consequences for both tax equity and tax efficiency. Despite its clear importance for tax administration, enforcement, and compliance, economists have only recently begun to explore the role of tax practitioners in the tax system. It is argued below that the existing literature on tax practitioners has two primary shortcomings: (1) the models generally do not distinguish among tax preparer types, and (2) there is a lack of evidence from micro-level data on the relationship between tax preparation mode and tax compliance. In this paper, an econometric model of tax preparation mode and tax compliance that distinguishes among tax preparer types is developed and applied to micro-level data. The remainder of the paper is organized as follows. Section 2 contains a brief review of the theoretical, econometric, and survey literatures on tax practitioners. In section 3 a simple choice model of tax preparation mode and tax compliance is presented to motivate the econometric specification that is employed in the study. In section 4 a trinary choice model of tax preparation mode is developed and incorporated into an endogenous switching model of tax preparation mode and tax compliance. Estimation is performed using micro-level data from the 1979 Internal Revenue Service (IRS) Taxpayer Compliance Measurement Program (TCMP) data files, which contain the results of line-by-line audits of a random sample of individual income tax returns. A description of this data source is provided in section 5, and the results of estimation are presented in section 6. Some concluding remarks are offered in section 7.

2. A brief review of the tax practitioner literature There is at present

no general

theory

of tax practice.

‘The authors caution that these figures may be biased upwards of taxpayers with complex returns in their sample.

Rather,

there exists a

due to the over-representation

B. Erard, Taxation with representation

165

small collection of studies that each focus on particular features of this institution. Scotchmer (1989a, b) and Beck et al. (1989) examine the role of tax practitioners in reducing taxpayer uncertainty. In contrast, Reinganum and Wilde (1991) consider their value in reducing the time and anxiety costs associated with tax return preparation and tax audits. Slemrod (1989) examines the usefulness of tax practitioners in uncovering legal ways to reduce tax liabilities, while Klepper et al. (1991) investigate their ability to exploit ambiguous features of the tax code to reduce taxpayer penalities for non-compliance. In section 3 a simple theoretical framework is presented to motivate an econometric specification of tax preparation mode and tax compliance. Although based on some of the ideas presented in the above studies, a distinguishing feature of this framework is that it allows for different types of tax practitioners. In practice, tax practitioners are a diverse group of individuals who provide a broad range of services for their clients. It is likely that both the tax preparation mode and tax compliance decisions are influenced by preparer characteristics. The econometric research on tax practitioners has been directed towards two central questions. First, ‘What sorts of taxpayers tend to seek assistand, second, ‘Do tax practitioners tend to improve or worsen ance? compliance with the tax laws? The first question has been addressed by Slemrod and Sorum (1984), Long and Caudill (1987), Collins et al. (1988), Slemrod (1989) and Dubin et al. (1992). The results of these studies are summarized in table 1. Together, these papers indicate that income, age, return complexity, and the marginal tax rate all positively influence the decision to hire tax assistance. In addition, married taxpayers, self-employed taxpayers, and taxpayers with many forms and schedules to complete are relatively more likely to use paid assistance. In contrast, taxpayers with high levels of education or substantial tax knowledge tend to prepare their own returns. In all but one of the above studies, tax preparation mode is treated as a binary choice problem: a taxpayer either prepares her own return or she hires someone to assist her. The exception is the study by Dubin et al. (1992), which was performed independently of and subsequent to the study presented in this paper. Dubin et al. estimate a multinomial choice model of tax preparation mode using an aggregate data version of the micro-level data set used in this study. Although their employment of aggregate data leads to differences in estimation technique and variable construction from the microlevel analysis presented here, both studies provide strong support for distinguishing among preparer types when analyzing the mode of tax preparation. None of the above studies provides evidence on the role of tax practitioners in tax compliance. In an econometric analysis of summary IRS tabulations of line item tax non-compliance by tax preparation mode, Klepper et al. (1991) find support for their theory that tax practitioners

B. Erard, Taxation with representation

166

Table Findings

of the econometric

1

literature

on tax practitioners.

Factors influencing the decision to use a tax practitioner _ ~_________.. Population Sign of Factor influence group Income

1, 2

Age Marriage No. of dependants Education Tax knowledge Self-employment Responsibility Value orthodoxy Return complexity No. of forms & scheds. Marginal tax rate Audit rate Penalty rate

1, 1 1, 5, 2,

1

2, and 6 6 6 3

2 3 3, 5, and 6 1, 6 I, 5 6 6

Study

+ + + + _ _ + _ + + + + + +

LC, CMT LC, CMT, DGUW LC LC, DGUW S, DGUW CMT LC CMT CMT CMT, S, DGUW LC, DGUW LC, s DGUW DGUW

Factors influencing expenditures on tax practitioners Factor

Population group

Sign of influence

Study

Income Age Self-employment Capital gains Wages Marginal tax rate

4 4 4, 5 5 5 5

+ + + + + +

ss ss ss, s S S S

Injluence of preparation mode on tax liability Long and Caudill (1987) find that, controlling for tax returns tend to show relatively low tax liabilities.

return

characteristics,

paid-prepared

Influence of preparation mode on compliance Klepper et al. (1991) find that paid-prepared returns show relatively more compliance when line item ambiguity is low and relatively more non-compliance when line item ambiguity is high. The size of the absolute difference in line item non-compliance across modes of tax preparation is found to be positively associated with the level of non-compliance opportunity. Key to population groups

Key to studies

1 Filers of 1983 federal income tax returns. 2 - 1988 Oklahoma and Pennsylvania taxwhose primary payers interest was tax minimization. 3 - 1988 Oklahoma and Pennsylvania taxpayers whose primary interest was a correct return. 4 - 1982 Minnesota taxpayers. 5 - 1982 Minnesota taxpayers who itemized their deductions. 6 - Filers of 1979 federal income tax returns (aggregate data).

CMT - Collins, Milliron and Toy (1988). DGUW - Dubin, Graetz, Udell and Wilde (1992). LC Long and Caudill (1987). SS - Slemrod and Sorum (1984). S - Slemrod (1989).

B. Erard, Taxation with representation

167

promote compliant reporting on unambiguously defined line items and non-compliant reporting on ambiguously defined items. Although the issues of tax preparation mode and tax compliance have been examined separately in previous studies, there is a strong case for their joint analysis. Opportunities for non-compliance are likely to differ across tax preparation categories, which can influence the choice of preparation mode. As is discussed below, the failure to account for the interdependence between the preparation mode and compliance decisions can result in biased inferences about the role of tax practitioners in tax compliance. In this paper, a trinary choice framework for the joint analysis of tax preparation mode and tax compliance is developed and applied to micro-level data. The tax preparation choices that are examined are: (1) Tax preparation by a Certified Public Accountant (CPA) or lawyer. (2) Tax preparation by or assistance from a non-CPA, non-lawyer.2 (3) Self-preparation of taxes. Surveys indicate that CPAs and attorneys are relatively more aggressive in their reporting practices than other tax practitioners. The IRS-sponsored Survey of Tax Practitioners and Advisors (1987) represents the most comprehensive tax practitioner survey to date. This study is based on personal interviews with 1,772 tax professionals from a national sample. The results of this survey indicate that CPAs and lawyers are much more likely than other preparers to report that their loyalties are with their clients when dealing with the grey areas of the tax law. Moreover, CPAs and attorneys are relatively more likely to approve of aggressive reporting activities such as deliberately misclassifying tax items or advising clients not to report deductions to reduce the chances of audit. Over 60 percent of CPAs and lawyers at least partially approve of signing a return without seeing the full documentation, if the possibility exists that the client will later produce it; many indicate a tendency not to probe in depth for secondary sources of income; and the vast majority are inclined to resolve all questionable items on a return that have a reasonable basis in favor of the client. Survey research by Coyne and Smith (1987), Kinsey (1987a, b), and Ayres et al. (1989) provides corroborating evidence on the aggressive reporting characteristics of CPAs and attorneys. The IRS allows CPAs and lawyers relatively more freedom than other tax practitioners in the range of tax services that they may provide. For example, in addition to preparing tax returns, they are permitted to represent clients at IRS conferences, hearings, and meetings. 3 In return for the greater range of services they may provide, CPAs and lawyers are subjected to additional ‘This category includes unpaid tax assistance. 30ther tax practitioners may perform these services only by becoming enrolled agents or enrolled actuaries. To become certified as an enrolled agent, one must pass a special written examination and periodically fulfill certain continuing education requirements.

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with representation

behavioral standards under IRS Circular 230. Client expectations may help to explain why, although they are subjected to higher standards of conduct, CPAs and attorneys are among the most aggressive of taxpayer advocates. Surveys indicate that the clients of CPAs and lawyers tend to have higher levels of income and more complex returns than the customers of other providers of tax assistance; not surprisingly, these clients tend to express greater concern for uncovering ways to reduce tax liabilities.4 CPAs and attorneys are much more likely than other tax preparers to be members of professional organizations, such as the American Institute of Certified Public Accountants (AICPA) and the American Bar Association (ABA). The AICPA and the ABA institute certain behavioral rules and guidelines for their members. For example, both groups prohibit members from submitting a return that is known to be inaccurate or misleading. They also encourage members to take precautions to avoid reporting inaccuracies, such as comparing the current year return with the return of the previous year. However, members generally are not required to substantiate information provided to them by taxpayers, and they are given fairly wide latitude in their interpretation of ambiguous features of the tax code. For example, a member may take any tax position so long as there is a realistic possibility of it being sustained, either administratively or judicially, if challenged.5 Thus, flagrant violations of clearly defined tax rules, such as not reporting wage and salary income, are prohibited. On the other hand, providing aggressive interpretations of vaguely defined laws, such as passive loss rules, is deemed acceptable. The AICPA and the ABA also provide their members with access to information about court rulings and legal issues that may be of use in devising strategies for reducing tax payments. The IRS (1987) survey indicates that CPAs and attorneys are much more likely to recommend tax shelters to their clients than other tax practitioners. In addition, they report spending a substantially greater portion of their time assisting taxpayers with tax planning activities. CPAs and attorneys often are hired to represent taxpayers at audits and appeals. This provides them with information about factors that result in audits and penalties, which may assist them in devising effective reporting strategies for their clients.

3. Model development In this section a simple choice model of tax preparation mode and tax compliance is presented to motivate the econometric specification of the following section. In this model a taxpayer chooses from three alternative tax %ee IRS (1987) and Kinsey (1987a, b) for further information on tax client characteristics. ‘This rule is provided in AICPA Statement of Responsibilityin Tax Practice, no. 1, and ABA Formal Opinion 85-352.

169

B. Erard, Taxation with representation

preparation modes: (1) preparation by a tax specialist (e.g. a CPA or a tax lawyer), (2) preparation by a non-specialist (e.g. preparation by a bookkeeper or a national tax service), and (3) self-preparation. The distinguishing features of these alternative modes of tax preparation are the perceived audit probability for a given level of evasion, the penalty rate, the availability of tax planning services, and the cost of tax preparation. Both types of tax preparers in this model have the ability to reduce the audit probability, P(E), and the penalty, OE, associated with a given level of evasion, E; however, it is assumed that tax specialists offer greater reductions in audit and penalty rates than non-specialists. This is consistent with the notion that tax specialists are relatively more adept at finding an arguable basis in the tax laws for questionable reporting positions. As compensation for their superior skills, the market price of tax preparation services, C, is higher for tax specialists than non-specialists. Depending on the taxpayer, the personal cost of self-preparation may be higher or lower than the cost of either form of tax assistance. In addition to tax preparation services, tax specialists exclusively offer tax planning services, which provide their clients with legal ways to reduce tax liability.6 Although other preparers do offer some tax planning services in actual practice, it was noted in section 2 that specialists like CPAs and attorneys provide a disproportionate share of these services. The additional fee for providing a legal reduction in taxable income of amount A is B(A), where B’(A) > 0 and #‘(A) > 0. Taxpayers choose the mode of tax preparation, the level of evasion, and the level of legal tax avoidance that yield the highest level of expected income net of taxes, penalties, and preparation costs. Thus, taxpayers are free to decide how much income to report under each mode of tax preparation. Although this assumption is somewhat extreme, it is not without empirical support. For example, Kinsey (1987a) reports that in a survey of 43 tax practitioners from the Chicago area, most practitioners stated that their reporting procedure was to ‘outline the options and leave it to the clients to decide’. Consider a taxpayer with true income, I: who faces a proportional tax rate, t. Expected net income under the alternative modes of tax preparation are as follows: prep. by a tax specialist:

Y - t Y + tE,, + tA - P,,(E,,)(B,, + t)Et,

- C,, - B(A), prep. by a non-specialist;

(1) Y - t Y + tE,, - P,,(E,,)(0,,

+ t)E,, - C,,,

6Legal tax avoidance is treated in a very simple way in this model. A more general of tax avoidance in models of tax evasion is provided by Cross and Shaw (1982).

(2)

treatment

170

B. Erard, Taxation with representation

self-preparation:

Y - tY + tE,-P,(E,)(O,+

t)E,-

C,.

(3)

The subscripts ts, ns, and s in the above equations indicate that the values pertain to preparation by a tax specialist, preparation by a non-specialist, and self-preparation, respectively. For each mode of tax preparation, it is assumed that aP/dE and a2P/aE2 are both positive. In order to decide among the alternative modes of tax preparation, the taxpayer must determine the optimal level of tax evasion under each mode given the perceived audit schedule and the penalty rate. For the tax specialist mode, the taxpayer also must determine the optimal level of legal tax avoidance. The first-order conditions for each of the modes of tax preparation are as follows: prep. by a tax specialist:

t- 2

ts

(8,, + t)&, - Pt,(& + t) = 0,

t -B’(A)=O;

prep. by a non-specialist:

self-preparation:

t- 2

t2

s

(O,, + t)E,, - P,,(0,, + t) = 0; ns

(0, + t)E, - P&f?, + t) = 0.

(la)

(24

(34

These equations implicitly define the optimal level of evasion for each mode of tax preparation. Define ylP,E as the elasticity of P with respect to E. At an interior optimum, the marginal benefit of evasion for a given mode, t, is just equal to the expected marginal cost, (Q+t)P(l +v~,~). A corner solution also is possible. If at zero evasion the expected marginal cost of evasion exceeds the marginal benefit, then no evasion will take place. The existence and level of evasion depend on the mode of tax preparation, the tax and penalty rates, and the shape of the perceived audit schedule. In the case of preparation by a tax specialist, the first-order conditions also determine the optimal level of legal tax avoidance. At an interior optimum, the marginal benefit of legal avoidance, t, is just equal to the marginal cost of avoidance, B’(A). If the marginal cost of avoidance at zero avoidance exceeds the tax rate, then a corner solution characterized by the absence of legal tax avoidance will result. The optimal values for tax evasion and legal tax avoidance from the firstorder conditions can be substituted back into eqs. (1) (2), and (3) to determine the preferred mode of tax preparation. A taxpayer will choose the mode associated with the highest level of expected net income, evaluated at the optimal levels of evasion and legal avoidance. The choice among tax

B. Erard, Taxation with representation

171

preparation modes in this model is influenced by differences across modes in the cost of tax preparation, the opportunity for legal tax avoidance, and the expected net benefits of tax evasion. Taxpayers who are subject to high personal costs of tax preparation and those who anticipate substantial reductions in audit or penalty rates from preparer usage will tend to seek tax assistance. The type of assistance employed depends on the tradeoff between the expected benefits of preparation by a tax specialist (lower audit and penalty rates and the opportunity for legal tax avoidance) and the additional cost of a tax specialist’s services. Econometric implementation

An econometric specification of the above model can be derived through the introduction of explanatory variables and stochastic disturbances. A stochastic specification of the perceived audit probability schedule allows for the possibility that observationally equivalent taxpayers using a given mode of tax preparation may exhibit different levels of tax evasion. As an illustration, consider the following specification:

where pj is a parameter vector, X1 is a vector of explanatory variables, and sj is a N(O,af) disturbance. The vector X, represents observable taxpayer characteristics that influence the perceived probability of audit. For example, the presence of income that is not subject to withholding, may provide taxpayers with an improved opportunity to underreport income without being audited. Substituting the above expression for Pj into the first-order conditions reveals that the probability of evasion within mode j is equal to

Prob

([ t_

("+t)exP{-(~(iX~+Ej)~

l+eXp{-(j?>X1+Ej)}

,O

1

1 ’

which simplifies to

where P2i and Pyi> Pzi (choice one),

Pi=

2,

if PTi < Pzi and P$ > Pzi (choice two),

3,

if Pfi < PJi and Pfi < Pf& (choice three).

The term Pi represents an observable indicator variable for the choice that is made. In the current analysis, the choices to be examined are: (1) Tax preparation by a CPA or a lawyer. (2) Tax preparation by or assistance from a non-CPA, non-lawyer.’ (3) Self-preparation of taxes. The above specification is sufficient to define the choice probabilities. For example, the probability of tax preparation by a CPA or a lawyer is equal to Pr{Pi=1}=Pr{(u,i-Uli)