The Effects of Tax Software and Paid Preparers on Compliance Costs

The Effects of Tax Software and Paid Preparers on Compliance Costs John L. Guyton and Adam K. Korobow, IBM Business Consulting Services, Peter S. Lee, Internal Revenue Service, and Eric J. Toder, the Urban Institute Abstract In recent years, the percentage of individual taxpayers using paid preparers and software has increased, while the share of taxpayers who self-prepare without software has dropped sharply. Using the Individual Taxpayer Burden Model developed by IBM Business Consulting Services for the IRS, we simulate the effects of preparation method on time and money costs of preparing tax returns. When we correct for self-selection bias, we find that each group on average selects the preparation method that costs the least for them. For example, software costs more than self-preparation for current self-preparers, but costs less than self-preparation for current software users. INTRODUCTION In the past decade, there has been a dramatic shift in the way individual income taxpayers prepare and submit tax returns. In 1993, according to data reported in the IRS Taxpayer Usage Study (TPUS), 41 percent of taxpayers prepared their own tax returns without software, while 51 percent used paid preparers and only 8 percent prepared their own returns on a computer. By 2003, the share of self-prepared returns without software had dropped by two-thirds to only 13 percent. The tax software share tripled in a decade to 25 percent in 2003, while paid preparer use – the most common preparation method – rose to 62 percent (Toder 2005).1 1 The TPUS data typically under-state the percentage of taxpayers who prepare their own returns by several percentage points, compared with final data drawn from the IRS Master File, but they accurately represent trends in tax preparation methods. In 2003, according to Master File data, 16 percent of taxpayers prepared their own returns without software, while 24 percent used software and 60 percent used paid preparers 2Overall, counting both paid preparers and self-preparers, the TPUS data also show a dramatic rise over time in the share of return prepared on a computer. Over 85 percent of tax returns were prepared on a computer in 2003 – 97 percent of the 62 percent of returns paid by preparers and 66 percent of the 38 percent of returns prepared by taxpayers. In contrast, in 1987, only 13 percent of tax returns were prepared on a computer.2 The increase in computer-prepared returns has been accompanied by an increase in the proportion of taxpayers who file their returns electronically instead of on paper. The percentage of returns filed electronically quadrupled over ten years from 12 percent in 1993 to 48 percent in 2003. The 2004 tax year will be the first year in which over 50 percent of returns are filed electronically. TPUS data show that through May 13, 2005 the share of individual tax returns filed electronically for tax year 2004 was about 54 percent. This paper summarizes results of research presented at the 2005 National Tax Association Spring Symposium. The research used the Individual Taxpayer Burden Model (ITBM), a simulation model developed by IBM Business Consulting Services for the IRS, to show how tax preparation methods affect compliance costs. The model has been described previously in Guyton et al. 2003. Details of the technical estimation 2 IRS TPUS data for 1987 do not show a breakdown of computer-prepared returns between those submitted by tax preparers and those submitted by taxpayers themselves. Assuming, however, that only preparers used software, the data show that at most 28 percent of returns submitted by preparers were done by computer. 3methodology used to generate these results and some further extensions of the analysis will appear in a forthcoming paper. Preliminary simulation results suggest that taxpayers selecting each preparation method are minimizing their costs of tax preparation, under reasonable assumptions about the value of a taxpayer’s time. This means that the availability of more tax preparation options makes compliance costs lower than they would otherwise be. Compliance burdens of the individual income tax remain high, however, because taxpayers cannot eliminate all major sources of compliance burdens (for example, record-keeping, gathering tax materials, tax planning) by preparing returns on a computer. Improvements in technology can only partially offset the effects of an increasingly complex tax code. BACKGROUND ON INDIVIDUAL TAXPAYER BURDEN MODEL Compliance burden is a well-known cost of administering a tax system. Research in this area goes back at least a century, with an extensive international literature on the measurement of these costs (see Evans 2003). Building on this research, the US Internal Revenue Service (IRS) is developing simulation models to measure the level of comp