Pareto Policy Solutions, LLC

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Pareto Policy Solutions, LLC is a policy analysis and advocacy firm committed to advancing sustainability through “smart” regulation: regulation that rewards, and does not penalize, superior performance.  Often, such actions leverage advances in science and technology and make the regulatory program itself more effective as well as more efficient.

A Nudge to Close the Tax Gap

tax form

The tax gap is the difference between what the federal government collects in personal and corporate tax revenue and what it should collect. This difference, on a percentage basis, is roughly 17%, meaning that about 83% of federal taxes are collected voluntarily (perhaps non-forcibly is more accurate). This is an impressive statistic. But the 17% noncompliance rate—roughly $450B—is not trivial.

Much study has gone into how to close this tax gap. 

One relatively new idea is “return-free filing,” in which the government prepares your personal income tax return based on information from your employer and bank and other sources. You would have the option of using this return or alternatively filling out your own return. This option is done in some other countries (e.g., Spain, Denmark). Californians have this option for filing state taxes, and 90,000 citizens availed themselves of this option last year.  Not only does it promise to close the tax gap, but it also reduces tax preparation time.

To behavioral economists, the idea of return-free filing is known as a “nudge,” a term (and book title) coined by two professors from the University of Chicago, Richard Thayer and Cass Sunstein. (Sunstein now teaches at Harvard.) The nudges Thayer and Sunstein advocate are entirely voluntary. A person can choose whether or not to go along or resist the nudge.  (To learn more about nudges, check out Thayer's blog.)

Nudges are used strategically by all types of organizations, not just governments. An example might be a company that offers a 401K plan with the default setting of automatic participation, unless the employee opts out. Another would be a nonprofit that presumes every member will renew his or her membership at the end of the year (and charge the member’s credit card accordingly), unless the member opts out.  One thing about such nudges—they influence behavior, sometimes in very significant ways.

To what extent would return-free filing address the tax gap? Only partly. Of the $450B annual tax shortfall, about $235B is due to individual tax return underreporting, and most of this is from self-employed individuals, who have rather complex tax returns. Return-free filing, on the other hand, works best with relatively simple and straightforward tax returns, the kind associated with about $68B (about 15%) of the tax gap.

Of course, this all assumes return-free filing at the federal level is legal. As of now, it is not, and Congress would have to change the law to make it an option. To date, such proposals have met with stiff resistance from a variety of powerful interest groups.  NPR and NBC News recently published a story describing the opposition to return-free filing.

To reduce the tax gap, the General Accountability Office (GAO) recommended, in a 2012 report, a panoply of approaches.  These include simplification of the tax code, enhancing information to the IRS from third parties, and greater expenditures on enforcement.  GAO didn’t mention return-free filing, but it ought to be added to the list.  Perhaps GAO needs a nudge?

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