Tax software and barriers to entry: are tax pros more like physicians or more like hair braiders?

Trish McIntire (Our Taxing Times) makes an important observation: computer software has significantly lowered barriers to entry in the paid tax prep industry:

As tax software has developed, home computer products and online filing have made it easier for the DIYer [do-it-yourselfer] to prepare and electronically file a return. This has given rise to two problems. The first is the taxpayer who did his own return by hand and then switched to a program and doesn't check the results. Joe Doe has been preparing his own return for years by hand and discovers one of the boxes. Before when he ran into something he didn't understand, he would grab the instructions, Pub 17 or call the IRS to find out about his issue. With the box, if he can find something like his issue, he is less likely to research and more likely to rely on the software handling it correctly. These don't worry me since they are more an IRS problem, in fact, I get many new clients from this group. The group that worries me is the DIYer, who tries to bring in a little extra money preparing returns. The boxes make it easy and too many people are tempted to do something they can not do by hand.

Economists like to analyze different kinds of industries by thinking about barriers to entry in those markets.

For example, there are high barriers to entry in the physician market in all states. You need to spend many years in college, medical school, residency, and there are many obstacles including organic chemistry, MCATs, and licensing exams. Physicians who want to go into private practice face additional barriers because they have to come up with up-front money to pay for equipping an office, hiring office staff (who are knowledgeable about the ins and outs of billing insurance companies, among other things!), malpractice premiums, etc., etc. There are also requirements for continuing education.

In fact, even if you want to go into the hair-braiding business, many states impose barriers to entry. The state of Virginia, for example, requires wanne-be paid hair braiders to complete an approved training program involving 170 hours of instruction in hair-braiding among other things.

A. In order to receive a license as a hair braider, an applicant must meet the following qualifications:

1. The applicant shall be in good standing as a licensed hair braider in every jurisdiction where licensed. The applicant shall disclose to the board at the time of application for licensure any disciplinary action taken in another jurisdiction in connection with the applicant's practice as a cosmetologist or hair braider. The applicant shall disclose to the board at the time of application for licensure whether he has been previously licensed in Virginia as a cosmetologist or hair braider.

2. The applicant shall disclose his physical address. A post office box is not acceptable.

3. The applicant shall sign, as part of the application, a statement certifying that the applicant has read and understands the Virginia hair braiding license laws and the board’s hair braiding regulations.

4. In accordance with § 54.1-204 of the Code of Virginia, the applicant shall not have been convicted in any jurisdiction of a misdemeanor or felony which directly relates to the profession of cosmetology or hair braiding. The board shall have the authority to determine, based upon all the information available, including the applicant’s record of prior convictions, if the applicant is unfit or unsuited to engage in the profession of hair braiding. The board will decide each case by taking into account the totality of the circumstances. Any plea of nolo contendere shall be considered a conviction for the purposes of this section. The applicant shall provide a certified copy of a final order, decree or case decision by a court with the lawful authority to issue such order, decree or case decision, and such copy shall be admissible as prima facie evidence of such conviction. This record shall be forwarded by the applicant to the board within 10 days after all appeal rights have expired.

5. The applicant shall provide evidence satisfactory to the board that the applicant has passed the board-approved examination, administered either by the board or by independent examiners.

After the applicant has complied with all of the foregoing requirements, taken the 170-hour hair braiding training course, passed the board certification exam, and paid a $70 licensing fee, he or she is duly licensed to hang out a shingle as a "board-certified hair braider." Only then is s/he legally allowed to practice as a paid hair braider in Virginia.

My own state, New York, poses even more extensive requirements for wanne be professional hair braiders: 300 hours of approved training. A braider with a Virginia hair-braiding license can't skip the extra hours required in New York unless she can show 5 years experience as an out-of-state hairing braiding pro.

Most economists think some sort of legal barriers to entry in the physician market are a good idea, because the risk of bad medical care may be hard for consumers to observe in advance. There's a strong "information asymmetry" argument in favor of licensing physicians.

On the other hand, most economists think that the risk of a bad braiding job is low enough that state licensing requirements for "board-certified hair braiders" create economic inefficiency. Whether such requirements are actually enforceable as a practical matter, however, is another question altogether. Many hair braiders operate very informally, working out of their own apartments or making housecalls. As a practical matter, I would guess that there may be quite a bit of "unlicensed paid hair braiding" going on in Virginia and New York, licensing requirements or no.

What about professional tax preparers?

Right now, there are very low barriers to entry in tax prep industry. As I've mentioned before, in 48 states anyone (even an illiterate and innumerate convicted criminal) can go into the tax prep business. No need to show any qualifications, no need even to register before hanging out one's shingle.

As Trish's post makes clear, in almost all states, anyone with an inexpensive laptop and out-of-the-box software can go door-to-door making housecalls doing paid tax prep--and possibly fool unsuspecting and hapless clients into thinking that he knows what he's doing. Thanks to inexpensive boxed software, it's easy for a well-meaning but quite incompetent person to appear to be a knowledgeable tax pro.

The downside of a bad braid job may be laughable and any damage should be temporary, readily apparent, and easily reversible.

The downside of a bad tax job is not so funny, not always apparent, and the damage is not temporary or easily reversible.

Is licensing tax preparers a practical answer, however? As a practical matter, it may be very hard for the IRS to enforce such rules, just as it's hard for states like Virginia and New York to enforce rules against unlicensed hair braiders.