IRS needs auditing power to close the ‘tax gap’ - Albuquerque Journal

IRS needs auditing power to close the ‘tax gap’

As the father of four adult daughters, I know as well as anyone that women are capable of accomplishing anything.

I try to remind them that men, on occasion, can also achieve success.

Former Supreme Court Justice Ruth Bader Ginsburg was married to Marty Ginsburg. Justice Ginsburg was well-known. Marty Ginsburg was a well-known tax attorney.

Janet Yellen is the 78th treasury secretary of the United States. This is an important position. Alexander Hamilton, the first treasury secretary, has his own musical.

Secretary Yellen’s husband is a well-known economist. He even won a little prize called the Nobel. George Akerlof did pioneering work in information asymmetry.

Akerlof’s best-known paper was written over 50 years ago. It described how asymmetric information could lead to a failure of a market. Specifically the paper described the market for used cars, which he called the market for lemons.

Asymmetric information means one party has superior information than the other. Without some way of balancing this inequality, adverse selection can destroy the market.

Obamacare established prices for health care, with government subsidies for lower-income people. This could cause healthy people to opt out of the market, knowing they would not need services required by the market.

This “adverse selection” would then leave only unhealthy people (lemons) in the market for health care. In time, health care providers would not be able to sustain this market for the unhealthy.

Akerlof chose a simpler illustration. There were two kinds of used cars, lemons and peaches. Sellers knew the quality of their cars, that is, whether they had a lemon or a peach.

Buyers did not know the quality of the cars. The buyers priced used cars assuming an average level of quality. This caused the peach owners to drop out of the market.

Buyers lowered prices as the quality of offerings dropped. This eventually led to only lemons being available. The market collapsed.

This paper was quite controversial and remains so. However, the lesson is when one party knows more than the other does transactions between the two can fail (in some manner) unless there is some credible way to assure quality.

Today we see several online services that offer a history of a used car and dealers who offer certification of used car quality.

How would Marty Ginsburg have interpreted this “lemons” work? Like a tax person rather than as an economist.

A tax person might link this to tax returns. We have a “self-assessed” tax system. This means you and I file our returns based on the information we have about our income and deductions.

The government does not know if our representations are accurate. The system can fail if there is no credible way to assure the quality of the taxpayer’s self-reported figures.

Technological improvements allow some signaling of the accuracy of tax filings. The IRS gets 1099 and W-2 forms reporting certain income (salary, interest, dividends) and deductions (mortgage interest).

Information reporting has increased because the government has pressed the issue. These efforts have reduced the asymmetric information.

Treasury has also increased the standards that apply to regulated tax return preparers. Regulated preparers are CPAs, enrolled agents and attorneys.

Regulated preparers cannot sign a return unless each position satisfies a particular standard. This standard has been raised over the years.

Unregulated preparers prepare most tax returns. Treasury has tried to oversee unregulated preparers. Courts have not allowed them to do this.

Without a credible measure of tax return quality taxpayers might be better off with unregulated preparers. They are not required to satisfy a particular standard of quality.

The best mechanism to assure quality of tax return filings is an IRS audit. Congress has reduced IRS resources specifically to reduce this oversight mechanism.

There are credible measures that show the “tax gap” has increased over time. This is the spread between what the government collects and what it should collect if everyone reported accurately.

The tax gap flows from asymmetric information — more importantly, from “market” failures to allow credible means of resolving these information asymmetries.

As we enter a new tax season, more lemons are being sent to the IRS Service Centers. There are well-known reasons for this.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.

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