How asking the right questions can nudge tax cheats into compliance

The nation’s most recent tax gap report — delineating the difference between what taxpayers owe in taxes and what they actually pay — is not encouraging. 

According to this report, the country leaves approximately half a trillion dollars on the table annually in uncollected tax revenue. These funds could help alleviate poverty, strengthen the nation’s infrastructure, address climate change, reduce the budget deficit or simply lower taxes.            

The sources of such tax noncompliance are not hard to identify. They include but are not limited to, instances where taxpayers fail to report cash earnings or hide earnings overseas.             

For decades, politicians and tax administrators have sought ways to narrow the tax gap. Their methods have largely been confined to providing additional oversight funds to the IRS and to expanding the use of third-party information returns, such as Forms 1099 that, for example, report bank-earned interest and company-paid dividends. These efforts have had some success, but the tax gap persists.            

Given political constraints on tax reform and a limited IRS enforcement budget, this is an opportune time to apply the power inherent in “nudges.” As developed by scholars Richard Thaler and Cass Sunstein, nudges are subtle ways to coax, without forcing, desirable behaviors while at the same time providing latitude to individuals to make their own personal choices. Nudges have proven pivotal in achieving behavioral changes in finance and health, yet their use has thus far been limited in the realm of tax compliance.             

But there is a perfect platform to institute low-cost nudges to improve tax compliance: the individual tax return, Form 1040. Social science studies indicate that individuals find it far easier to engage in acts of omission (e.g., failing to report income) than acts of commission (e.g., fabricating tax deductions). As currently structured, Form 1040 tacitly invites individuals to underreport their income through acts of omission. 

For example, a line item asking for “other income” allows taxpayers to conveniently “forget” cash income that was not reported on either a Form W-2 or 1099. An important way to nudge taxpayers toward greater compliance would be to instead utilize a series of direct tax return questions framed in a yes/no manner, designed specifically to force taxpayers to participate in acts of commission if they do not answer truthfully.             

To illustrate, consider a taxpayer who, in addition to earning a salary from his day job, moonlights as a painter, earning an extra $50,000 annually in cash. He is supposed to report this cash income on his Form 1040. However, he might report his day job salary as reflected on his Form W-2 and perhaps omit the cash from his side gig, rationalizing that Form 1040 did not ask a specific question regarding cash receipts. By contrast, if the painter were explicitly asked if he received any cash payments for his services, he might be more inclined to be forthright in his reporting practices rather than affirmatively lie.            

The bottom line is simple: In areas of known tax noncompliance, Form 1040 should ask pointed questions that put taxpayers in a position such that, if they do not answer truthfully, then they are committing acts of fraud. A visual depiction of this proposal appears in the Form 1040 prototype below in the section entitled “Business-Investment Income & Expenses.” It is accompanied by an admonishment that warns taxpayers to be forthright or risk being penalized because research shows that warnings such as this are instrumental in instilling compliance.      

Tax administrators have long been dogged by information asymmetry — the single biggest contributor to tax noncompliance — whereby taxpayers know critical data that they hide from the IRS. Revising Form 1040 in the manner suggested can fundamentally reshape the tax landscape, nudge taxpayers toward greater compliance and fund our country’s most vital initiatives, all at almost no cost to the government.              

Given all the advantages associated with nudges, one question remains yet unanswered: Why have the powers that be not seized this unique opportunity and revamped Form 1040 accordingly? 

Jay Soled is director of the Master of Accountancy in Taxation at Rutgers Business School. James Alm is a professor emeritus in the Department of Economics at Tulane University. Kathleen DeLaney Thomas is the George R. Ward Term Professor of Law at University of North Carolina School of Law.

Editor’s note: This piece was updated on March 2 at 9:26 p.m. to correct the authors’ titles and institutions.