Refund Anticipation Loans and the Tax Gap

Abstract

There has been a significant expansion of refundable credits over the past twenty years. This trend is likely to continue as part of federal policy to stimulate the economy and promote non-tax related social benefits. With the growing use of the tax system to deliver refundable benefits to individuals, the tax preparation industry as a whole has become, in some significant respects, a vehicle for cross-marketing of non-tax goods and services. Refund anticipation loans, or RALs, are one example of these non-tax products that paid preparers facilitate for their customers. RALS are short-term loans secured by a taxpayer's anticipated tax refund amount. A taxpayer will borrow against the anticipated refund, and will be required to repay the loan regardless of the size of the actual refund amount. The RAL lender issues the taxpayer the amount of the anticipated refund less any preparation fees, as well as any filing, finance, and processing charges. The IRS refund is then transferred directly to the lender to pay back the loan. RAL customers receive their money between two and six weeks faster than waiting for their refund check. RALs have created a substantial market, with about $900 million in loan-related RAL fees being generated annually. The creation of RALs has opened up a major market niche, with their popularity largely coming with the advent of the IRS's e-filing program, and their use often associated with the receipt of earned income tax credit (EITC)-generated refunds.

Over time, RAL providers have come under fire from consumer advocates, elected officials, and IRS officials. The criticisms of RALs have come from two general starting points: 1) a social policy standpoint that draws heavily from general consumer protection concerns, including that RALs compromise taxpayer privacy and unfairly drain away precious tax benefits through fees that are high when computed on an annual percentage basis, and 2) a more targeted tax compliance perspective examining the role that RALS play in contributing to the underreporting aspect of the tax gap. While noting that consumer privacy and general consumer protection concerns are independent bases for further regulation, this essay focuses on the debate over RALs' effect on tax compliance, and its contribution to the tax gap.

While RALs are regulated to a limited extent by the IRS and Treasury, the IRS and the National Taxpayer Advocate have raised concerns about whether RALS create incentives for less compliant behavior among preparers who facilitate access to RAL lenders. In 2008 the IRS issued an Advanced Notice of Proposed Rulemaking (ANPR), seeking comments to determine to what degree RALs and other similar products should be further regulated. The rule on which the IRS and Treasury were seeking guidance would prohibit the use of information obtained during the tax preparation process for the purpose of marketing any product. This new rule would, at a minimum, inject additional costs for preparers and consumers and likely limit their use in some way.

The question that the IRS raised in its ANPR focused on whether RALs contribute to increased demand for overstated tax refunds. This question itself raises many unanswered questions. For example, does the additional speed in which individuals receive money embolden inappropriate taxpayer conduct? If the answer is yes, assuming practitioners can influence taxpayer compliance decisions, will increased regulation of preparers generally or RALs in particular result in fewer taxpayers willing to misstate facts to generate an improper refund? Do additional profits derived from RALs contribute to preparers' willingness to turn a blind eye to existing due diligence rules? Or even worse, do RALs contribute to conditions where preparers themselves are facilitating the noncompliance through more preparer-generated noncompliance efforts? These questions highlight the lack of information that hampers policymakers in designing effective measures to reduce the tax gap. Until the IRS generates quantitative data that identifies, for example, preparer types and correlates error rates with types of preparers, and generates studies comparing error rates among preparers offering RALs as compared with non RAL-seeking taxpayers, it is difficult to justify taking measures that may effectively limit RALs on compliance reasons alone.

This essay argues that in addition to the importance of additional research relating to preparers to backstop heavy-handed regulatory efforts, the IRS should broadly consider the insights from responsive regulation, and in particular consider ways to encourage preparers to self-regulate. Self-regulation allows the IRS to preserve scarce compliance resources for egregious actors. The focus on RALs in this essay allows for a further inquiry into the special role that preparers play in our tax system, and reflects the possibility that meaningfully working with the preparer community can be a means to reducing the tax gap in the thorny area of refundable credits.

Keywords: tax, IRS, refund anticipation loan, tax gap