The economics of the tax prep industry

There are minimal barriers to entry in the tax preparation industry. In most states, anyone can hang out his or her shingle as a "professional tax preparer," without any form of licensing, testing, or certification.

According to the IRS, as of 2008, only two states regulate paid tax preparers: California and Oregon. In other states, including New York, it's much easier to open a tax prep business than to open a barber shop, beauty salon, or interior design business. Even a convicted criminal can go into the tax prep business, where he will have easy access to clients' Social Security Numbers and bank account information.

Here's a Brooking Institution article discussing a study of the tax prep industry in 2001. The Brookings study cited an estimate of 300,000 paid preparers in the country, most very small one-person operations.

Given the risks of identity theft, as well as the potential consequences of an inaccurately prepared tax return, many people understandably avoid sketchy unknown tax preparers and instead go for the security of one of the three "big names" in the industry: H&R Block, Jackson Hewitt, or Liberty Tax.

Of the three big national chains, H&R Block was and remains the largest, with a market share of about 14% of all returns prepared in 2001. Jackson Hewitt was a distant second with less than 2% market share at the time. More recent estimates place H&R Block at 13% and Jackson Hewitt at 4% of all returns filed. Relative newcomer Liberty Tax is in third place but has grown rapidly in recent years, thanks in part to its use of a creative and aggressive "guerilla marketing" campaign which uses hired "wavers" to stand out in the street wearing Statue of Liberty or Uncle Sam costumes to draw attention to the stores. H&R Block and Jackson Hewitt use more conventional approaches to advertising, including television and print ads as well as billboards. Block and Jackson-Hewitt spent $80 million and $25 million, respectively on marketing last year, according to estimates cited in this Wall Street Journal article.

Overall, the percentage of taxpayers using paid preparers grew from 40% in 1981 to 55% in 2002. All three of the big franchise chains, especially Jackson Hewitt and Liberty, focus heavily on the low-income segment of the market that is eligible for EITC.

Estimates are that volunteer tax preparers serve about 2% of EITC recipients, while paid preparers serve about 70% of the EITC market. According to this 2008 IRS SPEC presentation, IRS trained and certified volunteers prepare over 3 million returns each year, generating over $3 billion in total refunds, an average refund of about $1,000 per return. Volunteer tax preparers helped taxpayers to save an estimated $650 million in tax preparer and refund anticipation loan fees.

Higher income taxpayers are more likely to use "do-it-yourself" software (such as TurboTax or TaxCut--the latter is published by H&R Block) or to use more highly credentialed professionals such as CPAs or tax lawyers. Do-it-yourself tax software, including the market leaders TurboTax and TaxCut, is available free to taxpayers with incomes under $56,000 through the IRS Free-File program linked at the irs.gov website.

Some tax software providers provide free federal software to taxpayers of all income levels. For example, market leader TurboTax provides a free edition. Giving away free federal tax software can be a promotional tool that still enables to the vendor to charge fees for state tax preparation services. Also, a taxpayer who becomes familiar with the free version of the software may be a good prospect to upgrade to more expensive paid versions of the software down the road.