Working Paper Series
Villanova University Charles Widger School of Law Year 2007
Freakonomics and the Tax Gap: An
Applied Perspective
Leslie Book
This paper is posted at Villanova University Charles Widger School of Law Digital Repository.
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FREAKONOMICS AND THE TAX GAP: AN APPLIED PERSPECTIVE
LESLIE BOOK
TABLE OF CONTENTS
Introduction .....................................................................................................
I. Sumo, Bagels and Tax Cheating .............................................................
II. The Theoretical Context ..........................................................................
III. Structural Incentives Within the EITC Create the Motivation for
Intentional Symbolic Non-Compliance...................................................
IV. Visibility and the Claiming of Qualifying Children ................................
Conclusion.......................................................................................................
I
NTRODUCTION
Over the course of approximately nine years, I had the opportunity to
talk with Janet Spragens at length about many topics. One topic that took
up a lot of our time was the earned income tax credit (the “EITC”) and, in
particular, the Internal Revenue Service’s (the “IRS”) efforts to reduce the
error rate associated with the EITC. Janet was deeply concerned about
low-income taxpayers, and she felt to her core that IRS compliance efforts,
if not designed or implemented with the characteristics of the low-income
taxpayer in mind, were likely to be unduly burdensome and lead to
erroneous determinations. In testimony before the Oversight Board,
1
in
Professor of Law and Director, Federal Tax Clinic, Villanova University School of Law. I
am grateful for the research assistance of John Guinan and Jane Coogan, and the Villanova
University School of Law for its financial support of my research. Helpful comments on an
earlier draft were provided by Will do next round
1. Janet Spragens’s testimony before the Oversight Board is essential reading for those
interested in issues affecting low-income taxpayers. See, e.g., Janet Spragens, Professor of
Law, Fed. Tax Clinic, Am. Univ., Wash. Coll. of Law, Statement Before the IRS Oversight
Board (Feb. 1, 2005), available at http://www.treas.gov/irsob/meetings/2-01-
05/statement_spragens.pdf (discussing how Low-Income Taxpayer Clinics provide a critical
service to the IRS by both educating taxpayers about their tax obligations and by protecting
the rights of low-income taxpayers).
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comments to the IRS,
2
and in articles,
3
Janet strove to give voice to the
low-income taxpayer, and she cautioned administrators and legislators to
consider policies from the taxpayer’s perspective. At times, Janet was
critical of efforts that she felt placed taxpayers at greater risk, and she
suggested a measured approach to proposals like requiring the testing,
registration, and certification of income tax return preparers. Yet, Janet
was not one just for the status quo, and with that in mind, the inquiry about
what to do with the problem of non-compliance among low-income
taxpayers, and the EITC in particular, is a topic that I feel is especially
appropriate to consider.
I.
SUMO, BAGELS AND TAX CHEATING
The EITC error rate is high relative to other transfer programs, though
not as large in relative terms as other systemic areas of non-compliance
within the tax system.
4
Views differ on just how important the EITC
compliance problem is and the means to reduce this error rate.
5
This
Article argues that applying insights from the entertaining book
Freakonomics
6
can assist policymakers grappling with the thorny issues of
EITC non-compliance. In Freakonomics, using Steven D. Levitt’s insights
as a curious economist, the authors sift through data to address broader
issues of greater import. One key question they tackle is just how corrupt
people are in different settings, looking at, for example, the role incentives
play for school teachers who feed answers to students on tests,
7
and parents
2. See, e.g., Janet Spragens, Nancy Abramowitz & Leslie Book, Professors Comment
on EITC Precertification, 100 TAX NOTES 847, 848 (2003) (raising concerns over the IRS’s
proposed pre-certification program, which could increase compliance burdens for low-
income taxpayers and in turn deter a significant number from claiming the EITC that
Congress intended for them).
3. See, e.g., Janet Spragens & Nancy Abramowitz, Low-Income Taxpayers and the
Modernized IRS: A View From the Trenches, 107 TAX NOTES 1407, 1407 (2005) (asserting
that although the IRS Restructuring and Reform Act of 1998 generates significant efficiency
gains for the agency, those gains often compromise fair process for low-income taxpayers);
Janet Spragens & Nancy Abramowitz, IRS Modernization and Low-Income Taxpayers, 53
ADMIN. L. REV. 701, 701 (2001) (explaining that the IRS reorganization has the potential to
greatly benefit low-income taxpayers, but special attention is required to ensure that the
unique needs of this group are addressed); Janet Spragens & Nina Olson, Tax Clinics: The
New Face of Legal Services, 88 TAX NOTES 1525, 1529 (2000) (arguing that the
professional tax community needs to recognize the compliance problems that face low-
income taxpayers and affirmatively support a moratorium on annual tax changes).
4. Lawrence Zelenak, Tax or Welfare? The Administration of the Earned Income Tax
Credit, 52 UCLA L. REV. 1867, 1882-84 (2005).
5. See, e.g., Nina Olson & Janet Spragens, Point & Counterpoint: Certification and
Precertification for the Earned Income Tax Credit, A.B.A. SECTION OF TAXATION NEWS
QUARTERLY, Summer 2005, at 10, 10-13, 20 (capturing different views on the merits of the
IRS’s proposal to require certain EITC claimants to pre-certify eligibility).
6. STEVEN D. LEVITT & STEPHEN J. DUBNER, FREAKONOMICS: A ROGUE ECONOMIST
EXPLORES THE HIDDEN SIDE OF EVERYTHING (rev. and expanded ed. 2006) (2005).
7. See id. at 22 (noting that high-stakes testing has radically changed the incentives for
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of children at day care centers who fail to pick their children up on time.
8
In these scenarios, the authors examine how structural incentives create
great temptations and lead teachers and parents to attempt to game the
system by feeding students answers to tests,
9
or failing to discourage
parents to pick their children up on time.
10
Two of Levitt and Stephen J. Dubner’s examples stand out as
illustrations of why there may be a non-compliance problem among EITC-
claiming taxpayers. The first story considers sumo wrestlers. In sumo
wrestling, wrestlers compete in fifteen matches to stay in the top leagues,
and those who finish with a winning record qualify for larger pay and other
benefits.
11
The authors study the outcomes of matches between those who
are 7-7 and those who are 8-6, and note that in these matches, which do not
mean anything for the 8-6 wrestlers, but do mean a great deal in terms of
cash for the wrestlers with the poorer record, the 7-7 wrestler actually wins
around 80% of the time.
1
2
According to the authors, the 7-7 wrestler
should win less than 50% of the time,
1
3
and in matches where the outcome
is not crucial, the wrestlers with 7-7 records win only about 40% of the
time.
14
To the authors, this suggests collusion among the wrestlers, with
the structure of sumo greatly contributing to the propensity for the wrestlers
to game the system.
15
Levitt and Dubner also examine Paul Feldman, a former economist
turned small businessman in the Washington, D.C. area, whose business is
remarkably efficient and profitable.
16
His business is simple: early in the
morning, he delivers bagels and a plywood box with an opening for coins
and bills to a company’s snack room.
17
Later, he returns and collects the
cash box and any leftovers.
18
The business provided Feldman (and Levitt
teachers to cheat, since schools are now increasingly being held accountable for poor test
results).
8. See id. at 19 (explaining that when a three dollar late fee was imposed on parents
arriving to the day care center more than ten minutes late, the number of late pickups
actually increased because the amount of the fine was too small).
9. See id. at 22-23 (listing the various incentives that persuade teachers to cheat,
including the fact that “teacher cheating is rarely looked for, hardly ever detected, and just
about never punished”).
10. See id. at 19 (arguing that a three dollar late fee does not deter late pickups because,
among other things, it substitutes an economic incentive for a moral one).
11. See id. at 36 (maintaining that a sumo wrestler’s ranking affects every facet of his
life, including how much money he makes and how large of an entourage he carries).
12. Id. at 37.
13. Id. at 38.
14. Id. at 39.
15. See id. (concluding that quid pro quo agreements among the wrestlers is the most
logical explanation for why 7-7 wrestlers win such an unnaturally high percentage of
matches against 8-6 opponents).
16. Id. at 41-47.
17. Id. at 42.
18. Id.
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and Dubner) with an interesting window into customers’ honesty. After
tweaking the cash collection mechanism to limit the temptation to steal
(initially Feldman relied on an open basket and coffee can with a plastic
lid), he noted that the overall payment rate for bagels was about 89%.
1
9
Attempting to draw conclusions from the data, bagel whiz Feldman
recounted Plato’s tale of “The Ring of Gyges,” from The Republic.
20
In the
tale, a student of Socrates named Glaucon tells of a shepherd named Gyges
who comes upon a secret cavern with a corpse inside that wore a golden
ring.
21
Taking the ring, Gyges discovered that turning the ring permitted
Gyges to become visible or invisible.
22
Able to escape detection, Gyges
went on to commit horrible acts, such as seducing the Queen, murdering
the King, and seizing the throne.
23
Glaucon’s telling of the tale was
cautionary; is it so, as Glaucon stated, that invisibility defeats virtue,
leading to evil deeds?:
Suppose now that there were two such magic rings, and the just put on
one of them and the unjust the other; no man can be imagined to be of
such an iron nature that he would stand fast in justice. No man would
keep his hands off what was not his own when he could safely take what
he liked out of the market, or go into houses and lie with any one at his
pleasure, or kill or release from prison whom he would, and in all
respects be like a God among men. Then the actions of the just would be
as the actions of the unjust; they would both come at last to the same
point. And this we may truly affirm to be a great proof that a man is just,
not willingly or because he thinks that justice is any good to him
individually, but of necessity, for wherever any one thinks that he can
safely be unjust, there he is unjust.
24
Like Gyges, those scarfing down Feldman’s bagels for free or less than
full price have the benefit of invisibility. Surely, installing video cameras
or paying an employee to serve as a bagel cashier would reduce the
possibility of invisibility, and hence increase the payment rate. Those
solutions, however, create other problems, including adding technology and
labor costs, thus cutting profits, especially if the technology or labor costs
exceed the underpayment costs. Feldman considered companies with
payment rates above 90% as honest, and when rates were between 80% and
19. See id. at 44-45 (discussing that subsequent to 9/11, overall payment rate inched up
2%, which, according to Feldman, reflected either patriotism or an increase in a general
sense of empathy).
20. Id. at 46.
21. PLATO, THE REPUBLIC 56 (Benjamin Jowett trans., The World Publishing Company
1946).
22. Id.
23. Id.
24. Id.
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90% he found them “annoying but tolerable.”
25
Levitt and Dubner,
harkening Adam Smith, who described humankind’s innate honesty, look
to the nearly 90% of those paying for bagels as evidence that people are not
universally corrupt.
2
6
Levitt and Dubner’s insights suggest that policymakers concerned with
cheating should pay closer attention to structural incentives and the relative
ease in which individuals’ non-compliance falls outside the light of day.
Like Feldman’s bagel business, the tax system provides a window on the
propensity to cheat. Many academics and economists have noted that
incentives alone do not describe why people choose to comply or not
comply with the tax law,
27
where the overall compliance rate is probably
somewhere between 80% and 85%.
28
Yet, the possibility of detection and
visibility are significant factors in tax compliance. Not surprisingly, when
there is extensive information reporting to the IRS, as in wage income,
people report their income properly, with a compliance rate of 96%.
2
9
Where there is little information reported, people fail to report their
income, such as income attributable to sole proprietorships, where the
compliance rate is about 40%.
30
Taxpayer use of offshore credit cards and
complex trusts is like the turning of Gyges’s ring, cloaking the taxpayer
from the often distracted and overwrought eyes of the IRS.
A number of recent tax compliance changes and proposals reflect the
strong desire in tax administration to limit opportunities for taxpayers to
evade detection. These changes and proposals include: disclosure rules
pertaining to corporate tax shelters,
31
proposals to require financial
institutions to track and report the basis of securities,
32
and third-party
25. LEVITT & DUBNER, supra note 6, at 43.
26. See id. at 46 (“[A] lot of people steal from [Feldman], but the vast majority, even
though no one is watching over them, do not.”).
27. See, e.g., Leandra Lederman, Tax Compliance and the Reformed IRS, 51 U. KAN. L.
REV. 971, 973-74 (2003) (discussing the reasons why enforcement alone does not explain
the overall rate of tax compliance and noting how scholars have looked to factors such as
taxpayer morale, trust in government, and the use of tax compliance as a signal to explain
compliance rates that exceed what would be expected if taxpayers were responsive only to
audit rates and penalties).
28. See id. at 973 (reporting that the overall voluntary compliance rate is generally
estimated at 83%).
29. NAT’L TAXPAYER ADVOCATE, 2005 ANNUAL REPORT TO CONGRESS 395 (2006),
available at http://www.irs.gov/pub/irs-utl/section_2.pdf.
30. See, e.g., The Tax Gap: Written Testimony Before the S. Comm. on Fin. Subcomm.
on Taxation and IRS Oversight on the Tax Gap, 109th Cong. (2006) (statement of Mark J.
Mazur, Director of Research, Analysis, and Statistics, Internal Revenue Service), available
at http://www.sentate.gov/~finance/hearings/testimony/2005test/07260.pdf (stating that
individual income tax underreporting accounted for 57% of the overall tax gap in 2001,
totaling $197 billion).
31. I.R.C. § 6111(d) (2000) (amended 2004) (requiring registration of confidential
corporate tax shelters).
32. See, e.g., Joseph Dodge & Jay Soled, Reporting Tax Basis: Dawn of a New Era,
110 TAX NOTES 784, 784 (2006) (arguing that brokers should be required to report the tax
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information reporting of miscellaneous payments to corporations with
fewer than fifty shareholders.
3
3
Given that budget deficits often coincide
with a renewed emphasis on reducing the tax gap,
3
4
former Commissioner
Everson’s priority for renewed IRS enforcement,
3
5
and a limited
congressional appetite for increasing IRS spending on enforcement,
36
it is
no surprise that calibrating efforts to best reduce the tax gap has become an
increasingly important issue. Over the past few years, the IRS, in words
and action, has paid increasing attention to larger ticket tax issues, such as
tax abuses related to the corporate use of tax shelters.
37
Yet, despite an
increased emphasis on wealthier and corporate taxpayers, it is also not
surprising that among areas of the tax gap, the IRS disproportionately
directs scarce compliance resources on those with less voice in the system:
namely, the working poor who claim the EITC.
38
Some of the IRS’s efforts
basis of their investments in addition to their existing obligation to report the amount
realized upon the sale or disposition of an investment).
33. See NAT’L TAXPAYER ADVOCATE, supra note 29, at 394-96 (explaining that when
third-parties have to report information to the IRS, taxpayers report 96% of their income).
34. For example, Congress is looking at the tax gap as a means of addressing the
current budget deficit. See Heidi Glenn & Meg Shreve, Lawmakers Begin Hunt for Revenue
to Solve Long-Term Fiscal Gap, 114 TAX NOTES 496, 496 (2007) (“When Senate Budget
Committee Chairman Kent Conrad, D-N.D., pressed a panel of witnesses last week to
address ways to change the tax code in light of the nation’s looming revenue challenges, he
said he was pointing to a key step toward solving the nation’s fiscal problems.”). For
historical precedent, see James W. Wetzler, Commentary, Alan Plumley & C. Eugene
Steuerle, Ultimate Objectives for the IRS: Balancing Revenue and Service, THE CRISIS IN
TAX ADMINISTRATION 311, 343 (Henry J. Aaron & Joel Slemrod eds., 2004), available at
http://www.urban.org/uploadedpdf/1000636_IRS_objectives.pdf:
The Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) initiated a
period in which policymakers became willing to impose greater burdens on
taxpayers in order to harvest the revenues from improved tax compliance. Faced
with the need to restore fiscal stability after what they perceived as the excessive
1981 tax cuts, . . . drafters of TEFRA reviewed numerous potential ways to raise
revenue and concluded that improved tax compliance was a relatively attractive
option.
35. IRS enforcement statistics have increased in the most recent fiscal year. U.S.
GEN.
ACCOUNTING OFFICE, REPORT TO THE SEC’Y OF THE TREASURY, GAO-07-136, FINANCIAL
AUDIT: IRS’S FISCAL YEARS 2006 AND 2005 FINANCIAL STATEMENTS 35 (2006), available at
http://www.gao.gov/new.items/d07136.pdf; see Robert Guy Matthews, In-House Critic
Holds IRS Feet to the Fire, WALL ST. J., Mar. 21, 2006, at A4 (noting how IRS
Commissioner Everson has emphasized enforcement and has “something of a tough-guy
reputation”).
36. See Martin A. Sullivan, Closing the Tax Gap: One Step Forward, Two Back, 110
TAX NOTES 691, 692 (2006) (deeming restrictions on IRS spending “ludicrous,” as increased
IRS spending could actually reduce a fiscal deficit).
37. U.S. GEN. ACCOUNTING OFFICE, supra note 35, at 35 (“The IRS has and will
continue to enforce the law across all sectors, but is focusing on corrosive activities of
corporations, high income taxpayers, and other major violators of the tax code.”).
38. See Zelenak, supra note 4, at 1884-87 (discussing how the IRS moderately over-
weights enforcement of the EITC relative to other parts of the tax gap). In effect, the IRS’s
increasing use of math error procedures, and its reliance on external and internal databases
to detect likely noncompliant taxpayers for audit selection reflects this desire to detect likely
intentional noncompliant taxpayers with fewer agency resources allocated to the task.
Increased agency mining of external data is also a development in other benefits programs.
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have been particularly harsh, including freezing, without providing notice,
nearly 1.6 million low-income taxpayers’ refunds over a four-year period
under the IRS’s “Questionable Refund Program.”
3
9
Given that the IRS’s compliance efforts are at times overbroad and may
deter or discourage eligible taxpayers,
40
policymakers should consider
administrative or legislative changes that, on an ex ante basis, decrease the
incentives or opportunities for potentially noncompliant EITC claimants. It
is not a terrific stretch to make the analogy between delivering an EITC-
generated refund through a self-identifying tax return and delivering bagels
in a snack room with an unattended cash box.
41
Unlike other benefits
programs with extensive and almost universal pre-eligibility screening
tests,
42
to receive the EITC, taxpayers complete and file a tax return, and
unless the taxpayer is one of the roughly 2% audited, the low-wage worker
receives a benefit of up to $4,536 without consideration of eligibility.
43
In
other programs, like food stamps,
4
4
error rates are tolerable, with over-
payments hovering at or below 5%.
4
5
The most recent comprehensive
study indicates that following IRS compliance efforts, approximately 27%
to 32% of the EITC dollars still were claimed erroneously.
46
The EITC’s
See Amy Mulzer, Note, The Doorkeeper and the Grand Inquisitor: The Central Role of
Verification Procedures in Means-Tested Welfare Programs, 36 COLUM. HUM. RTS. L. REV.
663, 709 (2005) (discussing the use of computer matching as primary verification in the
Medicaid program).
39. David Cay Johnston, IRS Move Said to Hurt the Poor, N.Y. TIMES, Jan. 11, 2006, at
C1.
40. See Leslie Book, The IRS’s EITC Compliance Regime: Taxpayers Caught in the
Net, 81 OR. L. REV. 351, 391 (2002) (describing these eligible taxpayers’ sense of defeat,
despite the option of challenging the IRS’s denial of their eligibility in court).
41. See LEVITT & DUBNER, supra note 6, at 45-48 (detailing the design of this bagel
business and its rate of success).
42. See Mulzer, supra note 38, at 663-65 (discussing the role of eligibility restrictions,
benefit levels, and application procedures for means-tested social welfare programs).
43. See INTERNAL REVENUE SERV., DEP’T OF THE TREASURY, PUBLICATION 596:
EARNED INCOME CREDIT (EIC) (2006), http://www.irs.gov/pub/irs-pdf/p596.pdf [hereinafter
IRS 596] (providing guidance for taxpayers on how to apply for Earned Income Credit tax
benefits); INTERNAL REVENUE SERV., DEP’T OF THE TREASURY, EITC THRESHOLDS AND TAX
LAW UPDATES, http://www.irs.gov/individuals/article/0,,id=150513,00.html (last visited
Mar. 24, 2007) [hereinafter IRS THRESHOLDS] (listing maximum benefits for taxpayers in
tax years 2005, 2006, and 2007).
44. For a discussion of changes to the administration of the food stamp program,
including efforts to target incorrect claimants, see David A. Super, The Quiet “Welfare”
Revolution: Resurrecting the Food Stamp Program in the Wake of the 1996 Welfare Law,
79 N.Y.U. L. REV. 1271, 1377 (2004) (discussing that in some states a third or more of food
stamp applicants and recipients are investigated for fraud, even if the state does not have
probable cause to believe that an applicant or recipient participated in any wrongdoing).
More traditional benefits programs have intrusive and detailed verification procedures,
including home visits and the direct contacting of third-party witnesses. Id. at 1376-77.
45. See Dorothy Rosenbaum, Food Stamp Error Rates Hold at Record Low Levels in
2005, CENTER ON BUDGET & POL’Y PRIORITIES, July 11, 2006, http://www.cbpp.org/6-30-
04fa.htm (detailing overall trends in food stamp error rates and their implications and
possible causes).
46. INTERNAL REVENUE SERV., DEP’T OF THE TREASURY, EITC REFORM INITIATIVE
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error rate, especially in comparison to other benefits programs, has
contributed to legislative and executive branch scrutiny.
4
7
The EITC error
rate raises questions about the viability of continued broad support, and has
contributed to a variety of conventional and unorthodox approaches to
bring the error rate down.
48
The difference in error rates between traditional benefits programs and
the EITC relates to the tax system’s reliance on self-declared eligibility,
which results in significantly lower administrative costs but is much more
susceptible to program error.
49
In a recent Article, I looked at the non-
compliance problem among low-income taxpayers,
50
and argued that a
component of the government’s efforts to reduce those error rates should be
a strengthening of third-party due diligence requirements, including a
possible tiered level of gathering and reporting information to the IRS that
would vary based upon the experience of the return preparer and the
number of tax returns prepared.
5
1
Underlying my suggestions was both an
awareness that tax return preparers play an important role in the EITC and
a desire to increase compliance by addressing ways to shine light on
preparers and taxpayers, without materially increasing either direct or
indirect taxpayer costs. In this Article, I make two claims. First, the
current structure of the EITC presents structural incentives to certain
classes of taxpayers willing to mis-state eligibility for the EITC or facilitate
others’ misstatements. These classes include taxpayers with more than two
(2003), http://www.irs.gov/newsroom/article/0,,id=110296,00.html. In Fiscal Year 2006,
taxpayers claimed approximately $41 billion in EITC, with approximately $36 billion of
that refunded; recent IRS estimates are that between 23% and 28% of the $36 billion in
refunded EITC was improper. U.S. GEN. ACCOUNTING OFFICE, supra note 35, at 134-35.
47. See Improper Payments Information Act of 2002, Pub. L. No. 107-300, 116 Stat.
2350 (2002) (requiring federal agencies, including the IRS, to review programs that are
susceptible to improper payments). Professor Zelenak is critical of how the Office of
Management and Budget (“OMB”) has only requested from the IRS improper payment
information relating to the EITC: “Despite the rather obvious application of the Act to
improper refunds, the only program administered by the IRS for which the OMB has
requested improper payment information is the EITC.” Zelenak, supra note 4, at 1897. For
a highly critical appraisal of congressional and administrative attention to lower-income
non-compliance rather than non-compliance associated with higher-income taxpayers, see
Dorothy Brown, The Tax Treatment of Children: Separate But Unequal, 54 EMORY L.J.
755, 785-86 (2005).
48. Cf. Dennis J. Ventry, Jr., Welfare By Any Other Name: How We Can Save the EIC,
114 TAX NOTES 955 (2007) (suggesting that the EITC is on much firmer ground than in
prior periods and that some advocates’ suggestions that its compliance problems could lead
to its repeal are overstated).
49. See Zelenak, supra note 4, at 1881 (noting the apparent inverse relationship
between congressional tolerance for program error and the ratio of administrative costs to
program benefits).
50. See Leslie Book, Preventing the Hybrid from Backfiring: Delivery of Benefits to
the Working Poor Through the Tax System, 2006 WIS. L. REV. 1103, 1113 (2006)
(lamenting the lack of data for comparing rates of intentional non-compliance with
unintentional error leading to EITC non-compliance).
51. Id. at 1146-48.
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children and non-custodial fathers who maintain some connection to their
children, but who fail to meet the Internal Revenue Code’s (the “Code”)
residency requirement for EITC eligibility. Second, the relative invisibility
of the tax return filing process, and, in particular, the identification of
children that the taxpayer claims as qualifying children, emboldens
taxpayers to erroneously claim children who do not meet the Code’s
detailed eligibility requirements, and the residency requirement in
particular. After considering these two claims, I suggest prescriptive
policies that Congress and the IRS should consider to: (1) minimize the
structural incentives to cheat, and (2) increase the likelihood of exposure,
which provides a powerful ex ante deterrent effect on misstating eligibility.
II.
THE THEORETICAL CONTEXT
Before considering the EITC, it is helpful to place the discussion of
EITC compliance in the context of the considerable research regarding tax
compliance in general. Over the past thirty years, a significant amount of
research from a variety of social science disciplines has considered tax
compliance.
52
Economists, psychologists, and sociologists have
contributed to the discussion, offering research and, at times, conflicting
explanations regarding the dependent variable of whether a person is likely
to comply with his obligation to file an accurate tax return.
53
In the jargon
of social science research, the unifying theme among this research is a
search for explanatory reasons, referred to as independent variables, which
are the factors that lead to non-compliance. The disciplines’ approaches to
research reflect differing views of how and why the variables might be
related and the various disciplines’ choices of which variables to focus on
indicate, in part, their assumptions about what motivates human behavior.
In broad terms, the economic models of tax compliance assume rational
behavior, and that people will coldly consider compliance from the
perspective as to whether the expected utility of non-compliance exceeds
the utility of complying. To that end, researchers relying on the economic
model have looked to a variety of independent variables likely to affect the
calculus, including penalty rates, the likelihood of an audit, and
52. Lin Mei Tan and Adrian Sawyer, A Synoposis of Taxpayer Compliance Studies:
Overseas vis-a-vis New Zealand, 9 New Zealand Journal of Taxation Law and Policy 431, ,
433-37 (2003) (providing an overview of research into factors affecting tax compliance)
53. I am indebted to the excellent theoretical overview of the respective social science
approach to tax compliance research in Neil Brooks, Challenge of Tax Compliance, TAX
ADMINISTRATION: FACING THE CHALLENGE OF THE FUTURE 7, 19 (Chris Evans & Abe
Greenbaum eds., 1998). For a good survey of the tax compliance literature, see Pauline
Niemirowski, Steve Baldwin & Alex Wearing, Thirty Years of Tax Compliance Research:
Of What Value Is It to the ATO?, TAX ADMINISTRATION IN THE 21ST CENTURY 199, 211-12
(Michael Walpole & Chris Evans eds., 2001).
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complexity. This research has become quite sophisticated. There are
numerous studies testing the variables that economists believe contribute to
taxpayers’ decisions to comply with the tax laws. Psychologists and
sociologists have rightly pointed out that the economic model is
insufficient as an explanatory tool. Sociologists and psychologists alike
argue that framing a taxpayer as an amoral utility maximizer fails to
capture the complexities of human behavior and relationships, and fails to
explain why compliance rates exceed what would otherwise be expected if
people were solely evaluating compliance in terms of dollars and cents.
54
Accordingly, psychologists have emphasized factors influencing the
decision not to comply as related to individuals’ moral aversion or
acceptance of tax evasion, with sociologists examining factors like attitudes
toward government generally, distributional and procedural fairness of the
tax system, and demographical variances among taxpayers.
55
The
challenge among policymakers mining the social science research is that
the research is at times inconsistent and incomplete.
As Professor Brooks aptly summarizes, in a perfect or even merely
orderly world the research would lead to:
[A] theory about why people comply with the tax law from which an
interested tax administration department could deduce a comprehensive
compliance strategy. Naturally, no such theory has emerged from the
research. Like much empirical research, we end up learning how much
we do not know. In some of the research, it is difficult to be sure which
way causation runs[,] . . . in more controlled experiments conducted to
test for causation there are problems generalizing the results . . . and
theories based on some research have become so complex that they
explain everything, by tautology.
56
A survey of the quantitative tax compliance literature is a sobering
exercise.
57
The tax compliance literature is often lacking the sweep of
context, a true understanding of patterns of human behavior. To date, the
quantitative approach to tax compliance has failed to offer satisfactory
predictive generalizations. One perceptive commentator, Margaret
McKerchar, in addressing the shortfalls in the compliance literature, noted
54. See, e.g., Robert Cooter & Melvin A. Eisenberg, Symposium Norms & Corporate
Law: Fairness, Character, and Efficiency in Firms, 149 U. PA. L. REV. 1717, 1725 (2001)
(pointing to lawyers who become judges and high rates of tax compliance as examples of
human behavior beyond mere self-interest).
55. Brooks, supra note 53, at 20
56. Id. at 21-22.
57. See Niemirowski et al., supra note 53, at 211-12 (identifying sixty-four variables
for non-compliance, and bemoaning the contradictory and inconclusive research). “Beliefs,
personality traits, demographic variables and tax rates, opportunity, propensity to evade, and
various ‘external variables’ have also contributed to understanding compliance behaviour.
Yet despite the extensive research, there is still a paucity of consistent reliable predictors or
explanations of causality.” Id. at 211.
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that research has:
[B]een driven by the need to find one model that fitted [sic] (rather than
explained) all possible types of compliance behaviour and allowed
predictions to be made about the taxpaying population in general. In
doing so, assumptions . . . were often unrealistic and therefore reduced
the usefulness of the model to policymakers and administrators. For
example, it is unlikely that taxpayers are all utility maximisers, risk
averse or rational decisionmakers. . . . [P]eople exist in a dynamic
environment where there are a great deal of influences, of which some
are inconstant and others may have not yet been identified or studied by
researchers.
58
Facing the inadequacy and shortfalls of the existing compliance
literature, Professor McKerchar noted that researchers and policymakers
would be better served by abandoning the search for a “single model of
taxpayer compliance and consider[ing] the use of different models to
explain differing types of compliance behaviour.”
59
McKerchar continued
by noting the importance of identifying the various typologies of non-
compliance,
60
and urged that additional studies relate to actual observed
taxpayer behavior and focus group study.
61
Faced with the at times inconsistent findings, Professor Brooks
suggested that more research is needed, but in the meantime, policymakers
should focus on the rather straightforward strategy of reducing
58. Margaret McKerchar, Why Do Taxpayers Comply? Past Lessons and Future
Directions in Developing a Model of Compliance Behaviour, TAX ADMINISTRATION IN THE
21ST CENTURY 225, 242 (Michael Walpole & Chris Evans eds., 2001).
59. Id.
60. See id. at 243 (emphasizing the need for further research on tax compliance). I
began this project of applying the useful Kidder/McEwen typology to low-income taxpayers
in The Poor and Tax Compliance: One Size Does Not Fit All, 51 KAN. L. REV. 1145 (2003)
[hereinafter Book, One Size Does Not Fit All], and continued it with a focus on commercial
tax return preparers in my article Preventing the Hybrid from Backfiring: Delivery of
Benefits to the Working Poor Through the Tax System, supra note 50. This Article
continues that project; in future research, I hope to apply more qualitative research models
to help better explain how commercial tax return preparers affect tax compliance among
lower-income taxpayers.
61. McKerchar, supra note 58, at 243. An excellent example of a study that considers
taxpayer behavior is Joseph Bankman & Stewart Karlinsky, Developing a Theory of Cash
Businesses’ Tax Evasion Behaviour and the Role of Their Tax Preparers, 5TH
INTERNATIONAL CONFERENCE ON TAX ADMINISTRATION: CURRENT ISSUES AND FUTURE
DEVELOPMENTS 136, 167 (Michael Walpole & Rodney Fisher eds., 2002). Bankman and
Karlinsky interviewed hundreds of independent contractors, business owners and tax
preparers, all of whom spoke to the authors on conditions of confidentiality. Id. at 136.
Bankman and Karlinsky concluded that cash business owners primarily rely on their own to
under-report income though they concluded that some cash business taxpayers looked to
their return preparer to facilitate the non-compliance. Id. At 161-62 . The qualitative
approach that Bankman and Karlinsky deployed, rather than a pure quantitative approach
that focuses on causal relationships between variables, is a valuable means of learning the
dynamics of non-compliance, and I believe offers the potential for generating significant
insights for researchers and policymakers.
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opportunities for evasion.
62
This is consistent with Levitt and Dubner’s
approach of examining structural incentives and visibility, two key factors
that can contribute to the temptation to cheat. What follows in the next two
Sections is a consideration of how the current EITC creates opportunities
for individuals to affirmatively misstate eligibility. Lest advocates think
this paints an unfair picture of low-income taxpayers as cheaters, I am
intimately aware of some of the limitations of this Article’s approach.
First, this Article considers only a slice of the EITC compliance problem.
As I have indicated elsewhere, in considering the EITC compliance
challenge there are separate and often distinct compliance problems.
63
Some of the non-compliance relating to the EITC is facilitated and caused
by the supply part of the equation; that is, commercial preparers and other
return preparers who play a key role in the tax system generally and an
even larger role for low-income taxpayers. Likewise, preparers’ own
incentives to sell low-income taxpayers services and products that are
monetized by the very refunds that taxpayers claim on tax returns creates a
strong temptation for preparers to facilitate errors.
64
In addition, a
significant number of errors on the EITC relates to inadvertent errors that
taxpayers (or their preparers) themselves make. This Article largely
focuses on the taxpayer willing to intentionally misstate facts on a tax
return to ensure eligibility or enhance the amount of the EITC claimed. A
challenge for researchers is that there is little hard data on the various
motivations and reasons underlying the EITC errors, and there is not an
adequate understanding of the role that commercial preparers themselves
play.
65
I do not wish to suggest that low-income taxpayers are less
62. Brooks, supra note 53, at 22.
63. See Book, One Size Does Not Fit All, supra note 60, at 1165-77 (listing eight
categories of non-compliance, including reasons related to the complexities of the EITC
rules and procedure, people’s varying attitudes toward the tax system, and advice from tax
professionals).
64. The role that preparers can play in brokering or facilitating noncompliance is
illustrated by the actions of certain Jackson Hewitt tax preparation franchises, in which the
government alleged were pervasively engaged in fraudulent schemes to erroneously claim
the EITC and generally misstate tax liabilities. See http://www.usdoj.gov/tax/txdv07215.htm
(the government filed civil injunction suits alleging that the franchise operations filed
thousands of false tax returns resulting in $70 million in losses to the Treasury). I intend to
explore the complex role that preparers play in tax compliance in future research. For more
on some of the challenges to compliance associated with commercial return preparers, see
Regulation of Federal Tax Return Preparers: Hearing Before the Subcomm. on Oversight of
the H. Comm. on Ways and Means, 109th Cong. 1-2 (2005) (written statement of Nina E.
Olson, Nat’l Taxpayer Advocate), available at http://www.irs.gov/pub/irs-
utl/testimony_wm_oversight_returnpreparers.pdf (correlating the increase in electronic
filing and availability of ETIC funds with an increase in taxes being prepared by
“unenrolled” preparers and those for whom tax preparation is not the primary business).
65. See Janet Holtzblatt & Janet McCubbin, Issues Affecting Low-Income Filers, THE
CRISIS IN TAX ADMINISTRATION, 148, 170 (Henry J. Aaron & Joel Slemrod eds., 2004)
(arguing that the use of a variety of paid preparers makes it difficult to generalize their
impact, as a group, on tax compliance). Holtzblatt and McCubbin identify EITC error rates
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trustworthy as a class than other people, nor even that a majority of the
errors relating to the EITC stem from claimants’ intentional willingness to
misstate facts that enhance eligibility or create the conditions for eligibility.
Policymakers would benefit from a more nuanced understanding of the root
causes of the problem. More research and a clearer understanding of the
underlying reasons for errors will assist in crafting administrative and
legislative responses. It is true that the varied nature of the problem
suggests that the government must rely on a multi-faceted approach to
compliance, which includes a healthy dose of quality taxpayer service.
This Article is not a blanket condemnation of the EITC errors as all
intentional and driven by claimant conduct. Yet, a realistic discussion of
the issue must take into account that in the tax system generally, and with
the EITC in particular, there is ample opportunity to misstate eligibility.
Professor Brooks and Levitt and Dubner suggested that intentional non-
compliance follows opportunity, and this insight is as relevant for the EITC
claimants as it was for corporate taxpayers who participated in complex
corporate tax shelters in the late 1990’s and first part of this century.
66
III. STRUCTURAL INCENTIVES WITHIN THE EITC CREATE THE
MOTIVATION FOR INTENTIONAL SYMBOLIC NON-COMPLIANCE
On the demand side of the equation, I suspect that individuals respond to
perceived inequities in the current EITC, and act to redress those inequities
by claiming an EITC to which they are not eligible. Working in a legal
clinic representing low-income taxpayers for the past nine years has
provided me with numerous instances of claimants feeling that the current
system does not adequately reward low wage workers who may be
connected in some way to children who fall short of the technical
requirements of the qualifying child definition.
67
This frustration with the
EITC eligibility rules thus contributes to symbolic non-compliance in
effect, intentional non-compliance that taxpayers commit to address
perceived injustices in the system.
68
Two common instances relate to: (1)
taxpayers with more than two qualifying children, and (2) non-custodial
among different classes of commercial preparers, though there appears to be no meaningful
data on the reasons why the error rates differ. Id. at 170-71. Explanations for the varied
error rates include differing levels of respect for the tax laws, technical knowledge of the
law, and taxpayer characteristics among the differing classes of preparers. Id.
66. See generally JOHN BRAITHWAITE, MARKETS IN VICE, MARKETS IN VIRTUE 197-211
(2005) (discussing the rise of corporate tax shelters in the United States and Australia).
67. A qualifying child is: (1) a son or daughter, or sibling, or is a stepchild or eligible
foster child of the taxpayer; and (2) has the same principal place of abode as the taxpayer for
more than half of the tax year; and (3) does not exceed certain age requirements. I.R.C. §
32(c)(3)(A) (2000) (referring to § 152(c)). Lineal descendants of children, stepchildren and
siblings are also eligible to be considered qualifying children. Id.
68. Book, One Size Does Not Fit All, supra note 60, at 1174.
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parents (mostly fathers) who are connected to the minor children but who
fail the EITC’s technical residency requirements.
6
9
The current EITC is based upon the existence of earned income and the
residence of up to two qualifying children.
7
0
The presence of more than
two qualifying children does not affect the amount of EITC that can be
received.
71
Consider that the poverty rate for children in families with
three or more children is 26%, compared to 12% for families with only one
or two children.
72
Poverty is more prevalent among larger families, and the
EITC’s effectiveness is “poorly designed to address this pattern of child
poverty.”
73
To address this inequity, low wage workers with more than two
children are tempted to “share” the benefits with related parties who may
have earned income, but fewer than two qualifying children of their own.
74
Likewise, many non-custodial
75
parents are still connected in some
material way to their biological children, but because the non-custodial
parent fails the EITC’s residency requirement, he or she is unable to claim
the children as a qualifying child for purposes of the EITC. One of our
clients in the Villanova Federal Tax Clinic, for example, recently had his
EITC properly denied after audit when the IRS properly determined that he
was not the custodial parent. While not the custodial parent, he did spend
approximately three days per week with his children, who lived the balance
of the week with their mother, and he was the childrens’ principal provider
69. Other situations also lend themselves to symbolic non-compliance. For example,
nontraditional family arrangements also present a real challenge, as there are many
unrelated wage earners who live with the child and the child’s parent, but who may not be
married to the parent due to laws preventing gay marriage or other state benefits’ policies
that penalize adults for marrying. For a discussion of some of the challenges that alternative
families face in the tax system, and with the EITC in particular, see Patricia A. Cain,
Dependency, Taxes, and Alternative Families, 5 J. GENDER RACE & JUST. 267, 282-84
(2002). I have previously discussed the unfairness of the 2000 legislative change that
eliminated the ability for adults to treat children as qualifying children unless the children
are placed with the adult by an authorized placement agency. Book, One Size Does Not Fit
All, supra note 60, at 1184-86.
70. See IRS 596, supra note 43, at 1 (providing a summary of EIC requirements for
taxpayers to use as a reference).
71. See IRS THRESHOLDS, supra note 43 (listing maximum credit amounts for only
three scenarios: where the taxpayer has zero, one, or at least two qualifying children).
72. JASON FURMAN, CTR. ON BUDGET & POLICY PRIORITIES, TAX REFORM AND POVERTY
4 (2006), http://www.cbpp.org/4-10-06tax.pdf.
73. Id.
74. The other child-related provisions in the tax code, the dependency exemption and
child tax credit, are based on a per-child basis, though the value of the dependency
exemption is limited by its deductible rather than refundable nature, and the child-tax credit
is refundable only in a limited manner for lower-wage families with three or more children.
Id. at 4-5. Increasing the refundable nature of the child tax credit for lower-income
individuals would likewise have a significant effect on reducing the tax system’s incentives
for sharing children. See Brown, supra note 47, at 789 (2005) (noting the unfairness of the
CTC’s limited refundability for lower-income individuals).
75. By non-custodial, I mean parents who spend significant time with children through
shared or partial physical custody, but who do not spend more than half the year with the
child.
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of material support. Our client, a full-time low wage worker, claimed the
children as dependents, and the custodial mother signed a waiver
permitting the father to do so.
7
6
This is by no means a unique situation.
It is possible, at some cost, to minimize the structural incentives to cheat
in the above situations. Providing some additional EITC benefit for more
than two children will reduce the systemic temptations to cheat, and a
number of observers have suggested this solution on grounds other than its
effect on compliance incentives.
77
To address the situation with non-
custodial parents, the National Taxpayer Advocate has suggested creating a
separate credit for non-custodial parents who pay all required child support
in a given year.
78
This would likewise lessen the temptation for
cooperative unmarried or divorced parents to cheat when the custodial
parent has no or limited benefit from the EITC; in situations, for example,
where she has little or no earned income. The above proposed solutions are
within the framework of the existing EITC. In addition to the virtues of the
proposals within the framework of accepted policy objectives of the EITC,
including reducing the effects of childhood poverty and perhaps providing
proper labor incentives,
79
they lessen the existing structural incentive for
individuals to borrow or lend children to enhance their EITC eligibility.
There has been increasing attention to the possibility of a radical
overhaul and consolidation of the Code’s existing child benefits into one
unified refundable credit.
80
While these proposals have other merits
beyond an effect on compliance,
81
including considerations of efficiency
and fairness, an important consideration to such proposals is the possibility
76. I.R.C. § 152 allows for non-custodial parents to claim the children as dependents,
even if the non-custodial parent does not satisfy the residency requirement under the
dependency exemption. See Internal Revenue Service, Form 8332,
http://www.irs.gov/pub/irs-pdf/f8332.pdf (last visited March 24, 2007) (allowing for the
non-custodial parent in effect to transfer the child to the custodial parent for purposes of the
dependency exemption and child tax credit).
77. It may also address some of the negative effects that the EITC may have on groups
that have a higher incidence of larger families. See Brown, supra note 47, at 820 (noting
that blacks are more likely than whites to have larger families and thus are penalized for the
EITC’s failure to increase benefits for families with more than two qualifying children).
78. NAT’L TAXPAYER ADVOCATE, supra note 29, at 398.
79. See CTR. ON BUDGET & POLICY PRIORITIES, supra note 72 (discussing the EITC’s
impact on poverty and labor participation).
80. These ideas appear to be gaining more traction. For recent proposals, see
JONATHAN BARRY FORMAN, MAKING AMERICA WORK (2006) (noting government influence
on work behavior and suggesting alternative policies to create incentives for citizens to
work); President’s Advisory Panel on Federal Tax Reform, Simple, Fair, and Pro-Growth:
Proposals to Fix America’s Tax System (Nov. 1, 2005),
http://www.taxreformpanel.gov/final-report (suggesting ways to cut down on the complexity
of the tax code, including combining different tax provisions into one). For a spirited
defense of the use of refundable credits in the tax system, see Lily T. Batchelder, Fred T.
Goldberg, Jr. & Peter R. Orszag, Efficiency and Tax Incentives: The Case for Refundable
Credits 59 STAN. L. REV. 23 (2006).
81. See generally Batchelder, Goldberg, Jr. & Orszag, supra note 80.
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that a revised and combined credit provision might also limit the
opportunity or lessen the motive for individuals to game the system. This
consideration is apparent in some recent proposals, including the 2005
National Taxpayer Advocate Report that recommends combining the
dependency exemption, child tax credit, and aspects of the EITC into a
unified and refundable Family Credit available to all taxpayers, regardless
of income.
82
In her recommendation, the National Taxpayer Advocate
states that such a structure will minimize the temptation for individuals to
lend or borrow children.
83
One measure to evaluate such proposals and
their potential for creating the conditions for structural incentives is how
likely they are to provide benefits to individuals who have economic or
familial attachments to children, and whether the tax transfer mechanism
contributes to claimants acting like Japanese sumo wrestlers looking to
share prize money.
IV.
VISIBILITY AND THE CLAIMING OF QUALIFYING CHILDREN
The importance of visibility and information reporting on compliance is
both intuitive and somewhat irrational. Individuals overstate the likelihood
of audit, and when they know that the IRS has information pertaining to the
treatment of an item on a tax return, they are much less inclined to report
something that is inconsistent with information the IRS has already
obtained. According to Levitt and Dubner, visibility is a key factor in tax
compliance, and the wide divergence in income reporting among those self-
employed and those who earn wages from an employer is attributable to the
fact that those who are self-employed have much more incentive to cheat
because they know that barring an audit, the IRS has no chance of knowing
the self-employed individual’s true income.
84
Given the low audit rate,
even with individuals generally overstating the chances of audit, it is no
wonder that many taxpayers feel confident enough to underreport income.
Given the political challenges associated with giving the IRS additional
resources to reach more taxpayers
85
(Levitt and Dubner remind us of the
popularity of Michael Dukakis’ 1988 campaign promises to support a more
82. NAT’L TAXPAYER ADVOCATE, supra note 29, at 371.
83. Id. at 405.
84. Stephen J. Dubner & Steven D. Levitt, Filling in the Tax Gap, N.Y. TIMES, Apr. 2,
2006, at 26.
85. For a discussion of some of the political challenges associated with giving the IRS
additional resources to clamp down on tax cheating, see Ryan J. Donmoyer, Democrats’
Revenue Plans Might Mean Turning Taxman Into ‘Beast’, BLOOMBERG.COM, Mar. 5, 2007,
http://www.bloomberg.com/apps/news?pid=washingtonstory&sid=aU8SELY0OrWM
(quoting former Assistant Secretary for Tax Policy at the U.S. Department of the Treasury,
Pamela Olson, as saying that suggestions that the IRS should collect a significant portion of
the tax gap risk turning “the IRS into the enforcer Congress ordered it not to be less than a
decade ago”).
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vigorous IRS),
86
some taxpayers feel confident enough that they can file
incorrect tax returns and get away with underpaying what they owe, at
significant cost to those who pay their fair share.
8
7
In addition to the importance of visibility to the proper reporting of
income, it also is crucial for other aspects of tax compliance.
88
In a brief
discussion of tax compliance, Levitt and Dubner describe how the
requirement for individuals to list the actual social security number of any
person claimed as a dependent resulted in a substantial decrease in the
number of claimed dependents.
89
They recount the efforts of IRS employee
John Szilagyi,
90
who had the idea of requiring individuals to list their
claimed dependents’ social security numbers on their tax returns, resulting
in a significant decrease in the number of fictitious children claimed. The
authors estimate that there was an increase of tax revenue by about $3
billion per year.
91
This approach was a low-cost way of limiting the
opportunity for taxpayers to twist the ring or throw an invisibility cloak
around claimed tax benefits.
9
2
Many observers have noted that the tax system’s relative impersonal
approach to claiming benefits, especially in comparison to the detailed and
often in-person pre-benefits eligibility process of other benefits programs,
contributes to the higher error rates relative to these other programs.
93
86. Dubner & Levitt, supra note 84, at [OH: Insert pinpoint].
87. Recent estimates peg the costs to those who are compliant at approximately $2680
per household. WRITTEN STATEMENT OF NINA E. OLSON, NATIONAL TAXPAYER ADVOCATE,
BEFORE THE COMMITTEE ON THE BUDGET, U.S. HOUSE OF REPRESENTATIVES, THE IRS AND
THE
TAX GAP 1 (Feb. 16, 2007),
http://budget.house.gov/hearings/2007/08Olsontestimony.pdf.
88. For a discussion of the policy implications of requiring additional information
reporting in the tax system, as well as practical suggestions for situations that warrant
additional reporting, see id. at 4-6.
89. See LEVITT & DUBNER, supra note 6, at 21 (noting that as a result of the IRS
requiring social security numbers for dependents, seven million less children were claimed
on tax returns).
90. The story of Szilagyi is also told in Filling in the Tax Gap, Dubner & Levitt, supra
note 84.
91. LEVITT & DUBNER, supra note 6, at 239; cf. Ariel Rubinstein, Freak-Freakonomics,
3 The Economists’ Voice Issue 9, Article 7, http://www.bepress.com/ev/vol3/iss9/art7
(critiquing the magnitude of the effect of requiring taxpayers to list claimed dependents’
social security numbers)
92. The concept of visibility’s effect on tax compliance has been previously explored.
See Robert A. Kagan, On the Visibility of Income Tax Law Violations, 2 TAXPAYER
COMPLIANCE 76 (Jeffrey A. Roth & John T. Scholz eds., 1989) (concluding that the
“visibility” of income reporting violations by citizens determines the extent to which
citizens comply with the laws); see also Leandra Lederman, The Interplay Between Norms
and Enforcement in Tax Compliance, 64 OHIO ST. L.J. 1453, 1500 (2003) (noting that the
high compliance among those whose income is reported and identifying lack of opportunity
as a key factor in the high compliance rate).
93. See, e.g., Zelenak, supra note 4, at 1876-79 (comparing the EITC program, which
operates on the basis of self-declared eligibility, to food stamp programs or Temporary
Assistance to Needy Families, where claimants must complete a government required
process to establish eligibility).
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While EITC claimants (like other taxpayers) have the possibility of income
misreporting (though EITC-claiming taxpayers may have an incentive to
overstate or create earned income), the residence of qualifying children is
the most common EITC error,
9
4
and within that category, the residency
requirement is the most common error.
95
Unlike wage income, there is no
third-party information reporting requirement that would identify children
and addresses of record.
96
Other agencies responsible for administering
benefits programs where eligibility is dependent upon residency
requirements have relied on fairly intrusive measures to establish
eligibility, including pre-eligibility third-party contacts and visits to
homes.
97
In some ways, the IRS’s pilot pre-certification program,
98
which
required certain taxpayers to provide documentation establishing a claimed
qualifying child’s residence at or before the filing of a tax return, was an
effort to bring children outside of the shadows and impose on claimants,
rather than third parties directly, the obligation of reporting relevant
information to the IRS.
9
9
At present, the IRS does not plan to implement certification on a wide
scale, though the IRS is continuing to evaluate certification’s effect on
participation and the level of erroneous payments.
100
Under current
practice, how visible are the qualifying children that EITC-claimants list?
94. Holtzblatt & McCubbin, supra note 65.
95. Id. at 164-66.
96. While there are no information reporting obligations relating to residency, the IRS
does have access to data collected by the Department of Health and Human Services
(“HHS”) that relates to child support payments, and its computer system, known as the
Dependent Database, incorporates data acquired from HHS into the processing of individual
tax returns. This process helps guide the selection of returns for examination. See, e.g.,
TREASURY INSPECTOR GEN. FOR TAX ADMIN., THE SELECTION OF EARNED INCOME TAX
CREDIT RETURNS FOR EXAMINATION CAN BE IMPROVED TO FURTHER PREVENT ERRONEOUS
PAYMENTS (2003), http://www.ustreas.gov/tigta/auditreports/2004reports/200440004fr.html
(reviewing the IRS’s process of selecting EITC cases for examination using a cost-benefit
analysis and making recommendations to provide for a more productive combination of
returns for examination). Other benefits programs have increasingly relied on data mining
to assist in verification and compliance activities. See Mulzer, supra note 38, at 709
(discussing the use of data mining in the Medicaid program).
97. In the food stamp context, see David A. Super, The Quiet “Welfare” Revolution:
Resurrecting the Food Stamp Program in the Wake of the 1996 Welfare Law, 79 N.Y.U. L.
REV. 1271, 1377 (2004) (arguing that individuals will be less apt to take advantage of food
stamp benefit programs if doing so would increase their risk of fraud charges).
98. For a discussion of the IRS EITC certification tests, see Internal Revenue Service,
Earned Income Certification Test,
http://www.irs.gov/individuals/article/0,,id=118200,00.html (last visited Mar. 23, 2007).
99. Preliminary results from the IRS’s testing indicated that it likely deterred non-
compliant taxpayers from claiming the EITC; however, unlike merely listing a social
security number on a return, it did also increase the costs for those who were eligible and
also likely deterred some eligible taxpayers from actually claiming the credit. DEPARTMENT
OF THE
TREASURY & INTERNAL REVENUE SERVICE, IRS EARNED INCOME TAX CREDIT (EITC)
INITIATIVE: FINAL REPORT TO CONGRESS (2005), http://www.irs.gov/pub/irs-
utl/irs_earned_income_tax_credit_initiative_final_report_to_congress_october_2005.pdf.
100. U.S. GEN. ACCOUNTING OFFICE, supra note 35.
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It is worth recalling that approximately 70% of taxpayers claiming the
EITC use paid preparers.
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01
The claiming of the EITC is a rather
impersonal and invisible process, especially given that many taxpayers who
are willing to misstate information on a return have the benefit of blaming
another party (the return preparer) if the IRS does catch up with them.
Given that there are often cultural and language barriers between the
preparer and the taxpayer,
102
even assuming good faith and competence,
there may be legitimate reasons why a return claiming the EITC lists a
child who did not in fact live with the taxpayer for more than six months.
103
Paid preparers do have a due diligence obligation that requires them to
complete and retain a due diligence worksheet detailing the preparer’s
efforts at obtaining appropriate information.
104
Current rules do not require
the preparer to furnish the worksheet with the return, though for all
taxpayers claiming an EITC (except those claiming the relatively small
childless EITC), the return must also include a Schedule EIC.
1
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Schedule
EIC is a one-page sheet requiring certain information about the qualifying
child to appear on the schedule, including the child’s name, social security
number, year of birth, relationship to the taxpayer, and the number of
months that the child lived with the taxpayer in the year in question. The
taxpayer is not required to separately sign Schedule EIC, though the
taxpayer is required to sign the appropriate 1040, which contains a
statement to the effect that under penalties of perjury the taxpayer attests to
the truth, correctness, and accuracy of the return and accompanying
schedules and statements.
106
Within the norms of the tax system, where can more be done to shine
more light on taxpayers claiming the EITC, without infringing too far on
legitimate privacy rights
107
or imposing too great a cost on taxpayers or
101. ALAN BERUBE, THE BROOKINGS INST., THE NEW SAFETY NET: HOW THE TAX CODE
HELPED LOW-INCOME WORKING FAMILIES DURING THE EARLY 2000S 9 (2006),
http://www.brook.edu/metro/pubs/eitc/20060209_newsafety.pdf.
102. See Michael I. O’Connor, Tax Preparation Services for Lower-Income Filers: A
Glass Half Full, or Half Empty?, 90 TAX NOTES 231, 232-37 (2001) (discussing some of the
cultural and language barriers between preparers and low–income taxpayers).
103. The residency requirement is relatively straightforward, though temporary absences
can be disregarded for purposes of determining eligibility, and shared custody arrangements
between parents can be complicating factors.
104. A preparer must complete Form 8867, Paid Preparer’s Earned Income Credit
Checklist, or an equivalent form. The completion of the checklist must be based on
information provided by the taxpayer or reasonably obtained by the preparer. Treas. Reg.
§ 1.6695-2(b)(1) (2000).
105. Internal Revenue Service, Schedule EIC, http://www.irs.gov/pub/irs-
pdf/f1040sei.pdf (last visited Mar. 23, 2007).
106. For e-filed returns, the IRS has promulgated Form 8879, which the taxpayer signs
and the preparer retains for the later of three years from the filing of the return or the
return’s due date. Internal Revenue Service, Form 8879, http://www.irs.gov/pub/irs-
pdf/f8879.pdf (last visited Mar. 24, 2007).
107. For a consideration of privacy rights in the context of tax compliance, see Stephen
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third parties? I have previously argued that every paid preparer should be
required to sign the EITC due diligence worksheet and submit a copy of
that sheet to the IRS.
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To increase the visibility of the process, preparers
should also be required to furnish a statement to individuals who claim the
EITC with a summary of the EITC claimed. The statement should read
something to the effect of:
Based upon information you told me about [name[s]] age and
relationship to you, and that [name[s]] lived with you for more than six
months (or was temporarily absent from you), you claimed [name[s]] as
qualifying children for the earned income credit. As required by law, I
have furnished to the IRS a due diligence worksheet pertaining to the
EITC and am submitting to you this statement in accordance with
requirements under law.
I suspect that individuals who know that preparers will separately report
information about claimed qualifying children will be less inclined to
misstate information on their tax return. It will be much more difficult
(though not impossible) for individuals to hide behind preparer error when
given a separate clearly marked disclosure statement listing information
relating to the EITC. While it is true that the IRS could only detect errors
relating to residence by examining the tax return, I believe it would reduce
the temptation to cheat, akin to bagel whiz Feldman’s tinkering with the
box where money was collected and forcing claimants to take one more
affirmative step (receiving a clearly-delineated statement) before the
receipt of an EITC-generated refund.
Imposing additional reporting obligations on third parties will not,
however, have an effect on individuals who self-prepare their tax returns.
For those individuals, the IRS might require more self-disclosure and vary
the disclosure based upon certain variables, including the type of
relationship between the taxpayer and the claimed child and whether the
taxpayer has previously claimed the qualifying child. For example, I
suspect that married taxpayers who file a joint return and claim their
biological children as qualifying children are much less likely to claim an
improper child than a single parent filing as a head of household or an
uncle or aunt claiming a niece or nephew. Likewise, the first claiming of a
qualifying child seems an opportune moment to require more information
W. Mazza, Taxpayer Privacy and Tax Compliance, 51 KAN. L. REV. 1065 (2003)
(conceding that while preserving the confidentiality of taxpayer information usually
promotes compliance, some exceptions to this policy may be beneficial); see also Cynthia
Blum, The Flat Tax: A Panacea For Privacy Concerns?, 54 AM. U. L. REV. 1241, 1257
(2005) (noting that while IRS reporting requirements may warrant privacy concerns, a
constitutional issue regarding these requirements would only come about in the absence of
security precautions or unwarranted disclosure of private data).
108. See generally Book, note 50, at 1103 (discussing the EITC and the problems in
determining the reasons for taxpayer non-compliance).
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from a taxpayer, especially given that the non-compliance can become
habitual.
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To address the former situation, the IRS could promulgate a
different Schedule EIC that would require more information to be disclosed
(such as checking a box that would list common circumstances why the
child resided with the taxpayer in the year in question), and perhaps even
have a separate signature requirement directly on the Schedule EIC itself.
To deal with first time claimants, the form should directly ask the taxpayer
to disclose if this is the first time that the taxpayer is claiming the
individual as a qualifying child, and, if so, explain why.
110
CONCLUSION
There is much we do not know about tax compliance generally and
compliance problems of low-income taxpayers. While research in tax
compliance is flourishing, there are many unanswered questions relating to
what contributes to the misreporting of income and overstatement of
deductions and credits. Structural incentives and visibility are two factors
that appear to have an effect on individuals’ willingness to misstate items
on a tax return. In this Article, I argue that policymakers should consider
structural incentives and visibility in fashioning responses to the EITC
error rate. Perceived unfairness with the current EITC, combined with the
ease in which related parties can share the claiming of children, is likely a
factor in the EITC overclaim rate. The opportunity for collusion, as Levitt
and Dubner illustrate with their discussion of sumo results, creates
temptation and contributes to EITC overclaims. Likewise, the relative
invisibility of the residence of qualifying children also creates opportunities
for individuals to misstate eligibility. Generating additional disclosure
requirements for commercial return preparers and taxpayers themselves
will temper the temptation to cheat. While not a panacea for the multiple
reasons why individuals may misstate eligibility for the EITC, reducing the
109. See Robert Kidder & Craig McEwen, Taxpaying Behavior in Social Context: A
Tentative Typology of Tax Compliance and Non-Compliance, in 2 TAXPAYER COMPLIANCE
47, 62 (Jeffrey A. Roth & John T. Scholz eds., 1989) (explaining that habitual non-
compliance develops over time as the taxpayer learns what one can “get away with” based
on previous filings).
110. For example, the form could identify common situations when a taxpayer should
claim a child, including the birth of a child, a formal custody arrangement, the first presence
of sufficient earned income, etc. Increasing disclosure obligations on taxpayers themselves
has the risk of adding complexity, deterring eligible individuals from claiming the EITC, or
encouraging even greater use of commercial preparers. To judge this proposal’s
effectiveness, the IRS may wish to test its costs and benefits in a manner similar to what the
IRS did in evaluating the EITC pilot certification program. See IRS EARNED INCOME TAX
CREDIT (EITC) INITIATIVE: FINAL REPORT TO CONGRESS, supra note 99, at 10-11 (explaining
that in evaluating the certification program, administrative data regarding tax return
information was collected and surveys shedding light on the burden imposed by the
certification were conducted to assess the process on compliance and participation).
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possibilities of collusion, as well as increasing the exposure associated with
claiming the EITC, will serve the modest but important objective of
reducing the perceived and actual opportunities to misstate eligibility.
