Wednesday, September 23, 2009

Correlation vs. causality: tax pros and audit probability and LOVE

Tax Practitioner Credentials and the Incidence of IRS Audit Adjustments

2003, Accounting Horizons

John Hasseldine, Peggy A Hite


A random selection of Internal Revenue Service office audits from October 1997 to July 1998, the type of audit that concerns most taxpayers, is analyzed. Taxpayers engage paid preparers in order to avoid this type of audit and to avoid any resulting tax adjustments. Whether there are more audit adjustments and penalty assessments on tax returns with paid-preparer assistance than on tax returns without paid-preparer assistance is examined. By comparing the frequency of adjustments on IRS office audits, it is concluded that there are significantly fewer tax adjustments on paid-preparer returns than on self-prepared returns. Moreover, CPA-prepared returns resulted in fewer audit adjustments than non CPA-prepared returns. The study included 2,253 audit cases; 71% of the audited taxpayers prepared their own tax return, 19% hired a CPA, and 10% hired a non-CPA. Most adjustments come from deduction errors, and CPA-assisted returns have significantly lower likelihood of having a deduction adjustment.

Given that most paid preparers are not CPAs, a naive interpretation of the data above could lead to an erroneous conclusion, to wit: hiring a CPA to prepare your tax return "causes" a higher likelihood of IRS audit than hiring a non-CPA to prepare it.

An alternative explanation could be that the subset of taxpayers whose finances are sufficiently complicated as to make them likely to attract the interest of the IRS are also more likely to hire a CPA than they are to hire a non-CPA.

Since the study also found that IRS audits in the sample turned up fewer errors on CPA-prepared returns than on non-CPA-prepared returns, choosing a CPA might well have been a very good decision on their part.

In a study such as this one, there are always many unobserved variables which could be a source of what econometricians refer to as LOVE ("Left Out Variable Error.")

The sample of taxpayers selected for office audit is clearly not a random representative cross-section of taxpayers. Taxpayers who prepare their own tax returns are a minority of taxpayers, but they constituted 71% of those audited in the study sample. It's an interesting question as to whether preparing your own tax return raises the probability of audit, after statistically controlling for the complexity and other attributes of the return.

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