Refund anticipation loans and the tax gap.

• Author: Book, Leslie
• Position: Symposium: Closing the Tax Gap

1. INTRODUCTION

   The tax gap is an issue drawing increased legislative and administrative attention. The IRS estimates that the gap, the difference between taxes that are legally owed and taxes that are paid on time, was $345 billion for tax year 2001. (1) Voluntary compliance is approximately 83.7%, and the IRS estimates that each percentage of noncompliance costs approximately $21 billion. (2) In the past Congress has admonished the IRS for failing to come up with a comprehensive plan for reducing the tax gap. (3) In 2007, the IRS and Treasury responded by releasing a report outlining the steps the IRS is taking to reduce the tax gap, and outlined the agency's comprehensive plan to attack the elements that contribute to the overall tax gap: nonfiling, underreporting and underpayment. (4)

   The increased agency and legislative attention on the tax gap coincides with a time of increasing budget deficits and the related governmental quest for increasing revenues without increasing the tax rates or expanding the tax base. (5) Looking for extra dollars from noncompliant taxpayers is less likely to generate political backlash than increasing taxes. Reducing the tax gap is largely a bipartisan rallying cry. (6) Though, as this Article reveals, efforts to reduce underreporting are not free of political risk, especially when targeted at well-heeled and organized parties likely to bear the costs of government efforts.

   This Article will look at one such effort: the IRS's attempt to reduce noncompliance associated with lower-income individuals seeking refund anticipation loans (RALs). RALs are loans secured by taxpayers' expected tax refunds, and they have become part of the blossoming tax return preparation industry. (7) Approximately fifty-six percent of RALs are associated with taxpayers who claim the earned income tax credit (EITC), (8) a refundable credit targeted to low- and moderate-income individuals. (9) The RAL lender will issue the refund amount to the taxpayer, less any tax preparation, filing, processing, and finance fees. The sum total of these fees can be quite high: from roughly $150 up to $500, depending on the preparer and lender. (l0) RALs have created a substantial market, with about $900 million in loan-related RAL fees being generated annually. (11) The presence of fees, and the existence of ancillary service or product providers at or in proximity to the return preparers, raises the question as to whether the allure of these fees is encouraging tax return preparers to act improperly and contribute to the compliance problems associated with returns associated with EITC-fueled refunds. (12)

   This Article argues that our general lack of understanding of how return preparers contribute to the decision to comply (or not comply) with our nation's tax laws limits the ability for policy makers to take effective administrative or legislative action aimed at reducing the tax gap associated with returns that are associated with RALs in general, and the EITC in particular. It will look at one such administrative effort, the Treasury's Advanced Notice of Proposed Rulemaking (ANPR), (13) issued in January 2008, which asked for guidance on whether the selling of RALs should be restricted due to such products potentially creating an incentive for preparers to fail to comply with due diligence requirements designed to ensure the accuracy of refund claims. (14) While I applaud the IRS's efforts to examine the relationship between incentive and noncompliance, (15) and while there may be sufficient non-tax policy reasons to further regulate such products, (16) I do not believe that there is sufficient evidence from a tax compliance perspective alone to take action that would effectively limit its use. The ANPR highlights the preparers' role in taxpayer compliance decisions, and it is possible that RALs contribute in some way to both taxpayer and practitioner decisions to fail to comply with internal revenue laws. However, the current state of research in this area does not tell us enough about the degree to which RALs contribute to or exacerbate noncompliance problems, either from a demand perspective (i.e. taxpayers themselves), or from the supply side (i.e. the preparers). It is likely that other factors inherent in the relationship between practitioner and the refund-claiming taxpayer contribute to this noncompliance to a greater degree than the presence of RALs, factors such as: 1) the existence of the refund itself and the ability for the preparer to earn preparation fees from that refund; 2) the lack of ongoing relationship between the preparer to either the taxpayer or the tax system generally; 3) competitive pressure on preparers faced with other preparers willing to facilitate or broker tax refund noncompliance; and 4) the relative paucity of IRS audits of preparers to ensure that preparers are meeting up to their various responsibilities.

   Part II of this Article situates efforts to reduce the tax gap attributable to low-income taxpayers within the broader context of efforts to reduce the tax gap overall. Part III discusses the arguments that advocates have made in response to the IRS's request for information regarding the effect of RALs on the tax gap. Part IV analyzes the incentives for paid preparers to inflate refunds and discusses how the IRS should turn its immense fact gathering and research capabilities to the issues of practitioners and how practitioners can influence compliance decisions, (17) Part V uses the responsive regulation framework to analyze how the tax laws might be better structured to encourage compliance.

2. GONG AFTER THE BAD GUYS: SOMETIMES EASY, SOMETIMES NOT SO EASY

   Tax gap research and data highlight that there is not one tax gap problem, but a series of often distinct areas of systemic noncompliance. (18) Consider the case of the cash economy and small business taxpayers. The cash economy and small business taxpayers comprise a significant portion of the tax gap. (19) As Professor Bankman has noted, (20) the risks of popular backlash against the invasive audits necessary to meaningfully ferret out small business noncompliance, as well as the extent of agency resources needed to perform that labor-intensive work, are real and practical impediments to successful reductions in this portion of the tax gap. (21)

   Coming on the tenth anniversary of the IRS Restructuring and Reform Act of 1998, (22) IRS has stepped up its compliance activities in many areas to pre-1998 levels. (23) IRS efforts at reducing underreporting have targeted both the very rich, and the working poor, but have largely steered clear of some of the heavy lifting needed to go after those in the middle. (24) Facing widespread criticism that IRS audit rates of people claiming the EITC were too high relative to other taxpayers (25)--only one percent of taxpayers are audited, but nearly forty percent of audits are of returns claiming the EITC (26)--former Commissioner Everson redirected agency resources toward corporate tax abuse and well-publicized shelters. (27) Despite this shift in resources, however, the criticisms have continued. (28) It is fairly easy to explain how the IRS can get away with hundreds of thousands of annual audits of EITC-claiming taxpayers--this group is largely without the voice and power of small business taxpayers, and the "Nickel and Dimed" population is often without the means necessary to raise a ruckus in such a way that politicians or the agency takes note. (29)

   For the rich and corporate America, part of the reason why the IRS has been able to place in its compliance crosshairs corporate tax shelters is the backlash following Enron. With the Enron scandal and the publicizing of the arcane (often tax driven) schemes that had the potential to make the corporate income tax truly voluntary, (30) the Bush Administration put high on its priority list the aggressive tax shelter industry that flourished in the 1990s. (31) Even in a business-friendly Republican Administration, major figures in Treasury and the IRS railed against corporate irresponsibility and even a lack of patriotism associated with corporate tax-driven schemes. (32) While the administration could cite to success in its efforts to root out perverse corporate tax abuse, even declaring that the tax shelter war "was over" and "the government won,''33 the government has had somewhat less success in some of its other efforts to target noncompliance among wealthy individuals, including its offshore credit card initiative, (34) which held much promise in rooting out garden variety fraud, but likely would have generated intense backlash given the size and power of the people who the IRS would have targeted. (35) Without the popular indignation that surrounded the Enron-type corporate malfeasance, the IRS apparently decided not to pursue individuals with offshore credit cards, despite the high probability that those individuals were using those cards as a way to hide cash that was likely not reported to the IRS as income, (36) though recent pronouncements suggest that the IRS is moving away from this "hands-off" approach. (37)

   The IRS efforts of the past few years to reduce underreporting noncompliance among corporate taxpayers and the very poor appear on the surface to be paradoxical. Yet, those two groups are the proverbial low hanging fruit, with the working poor too powerless to meaningfully object, and the IRS beholden to a Congress controlling its purse, itching to show voters (especially in times of economic slowdown) that corporate America would not run roughshod over the income tax system.

   The lower-income tax return fliers are the lowest of the hanging noncompliance fruit. The IRS--prodded by Congress and the reality that many lower-income individuals enter the tax system not as income taxpayers, but as refund-seekers--annually puts hundreds of thousands of lower or moderate-income individuals through the paces of...