JATA - Spring 1994

Volume 16, No. 1

The Effect of Prepayment Position
on Individual Taxpayers' Preferences
for Risky Tax-Filing Options

Richard Dusenbury


The influence of prepayment position (payment due or a refund available) on taxpayers' preferences for risky filing options was investigated in an experimental study. The within-subjects experimental design was based on prospect theory. Experienced taxpayers completed three tax cases with differing prepayment positions and two non-tax cases. The taxpayers' choices evidenced preference reversals that violate axioms of expected utility theory. The taxpayers selected significantly riskier filing positions and reported less income in the payment-due case than in the refund case.

The Relation Between the Use of Tax
Preparers and Taxpayers'
Prepayment Position

Charles W. Christian, Sanjay Gupta,
Gary J. Weber, and Eugene Willis


This paper presents evidence from 7,127 tax returns on the relation between tax preparer usage and taxpayers, prepayment position (refund/balance due) and total prepayments. Prepayment position is measured as total prepayments minus tax liability. Using a two-step estimation procedure that corrects for taxpayers' self-selecting return preparation mode, we find evidence of preparer effects on prepayment position and total prepayments. Specifically, paid-prepared returns have relatively larger refunds and smaller total prepayments. Together, this implies that paid-prepared returns have lower tax liabilities and that the reduction in tax liability is larger than the reduction in total prepayments.

The Effects of Increased Sanctions on Paid
Tax Preparers: Integrating Economic
and Psychological Factors

Andrew D. Cuccia


The threat of economic sanctions has traditionally been used to influence the tax reporting decisions of both taxpayers and paid tax preparers. The penalties and reporting requirements faced by preparers have increased significantly in recent years and continue to be the subject of much debate. There is little evidence, however, that such penalties influence the recommendations of paid preparers. In this paper, a preparer model is developed that predicts that the threat of economic sanctions should affect (1) the aggressiveness of recommendations made by preparers when faced with ambiguous issues and (2) the effort invested by preparers in identifying taxpayers' unambiguous reporting positions. Client expectations and role perceptions held across preparer groups, however, are expected to moderate the impact of economic sanctions.

To test the model, commercial tax preparers and CPAs were given an interactive tax preparation task. The model's predictions related to preparer effort were supported for both preparer types. When exposed to a strict liability penalty, commercial tax preparers invested less effort in identifying tax reporting items that were expected to increase the exposure to the penalty. CPAs, however, increased their effort level. The penalty threat had limited effect on the aggressiveness of recommendations regarding ambiguous issues. The results suggest that increased economic sanctions may affect the effort invested by paid preparers in identifying legitimate ways of reducing their client's tax liability while having little effect on how aggressively they interpret ambiguous issues. The results provide evidence of a "backlash" effect of increasing sanctions on paid tax preparers that is contrary to the goals of tax lawmakers and administrators.

An Experimental Approach to Changing
Taxpayers' Attitudes Towards Fairness
and Compliance via Television

 Michael L. Roberts


Prior research has demonstrated a link between attitudes towards fairness and tax compliance intentions. This research describes an experiment designed to improve taxpayers' perceptions of the fairness of the federal income tax system and, thereby, their attitudes about tax compliance. Two sets of three 30-second public service announcements were created and shown to various groups of students and more experienced taxpayers. Post-experimental questionnaires were administered to measure differences in between-group attitudes about tax fairness and compliance. The results indicate that the public service announcements were effective in improving viewers' attitudes towards both the fairness of the income tax and tax compliance. These results suggest that carefully targeted mass media, public service advertising is a potentially effective method for improving public perceptions about tax fairness and attitudes towards compliance.

The Role of Taxes in Early
Debt Retirement

Gil B. Manzon, Jr.


This study examines firms that retired debt early to provide evidence on the relation of tax status to the net change in debt associated with early debt retirement and the gain or loss recognized at retirement. An easily computed estimate of the present value of taxes payable is used to identify firms' tax-related incentives. Test results indicate that: (1) low tax firms retire debt early to reduce interest tax shields that cannot be used efficiently, (2) firms use early debt retirements to reduce leverage when it exceeds an optimal level and (3) low (high) tax firms are more likely to select for early retirement debt that results in a gain (loss).

 An Isolation of the Effects of Personal
Deductions, Tax Credits, and the Tax Rate
Schedule on U.S. Individual Income Tax
Progressivity and Income Inequality

 Ananth Seetharaman


Scholars suggest that the redistributive property of personal expense deductions and tax credits has important equity consequences, some positive and some negative. In this study, Statistics of Income (SOI) data for 1989 are used to isolate the precise impact these deductions and credits have on overall tax progressivity and income inequality. The empirical findings reveal that, except for the medical expenses and casualty losses, itemized deductions reduce the progressivity of the federal individual income tax by up to 17.83 percent. Additionally, they cause the after-tax income distribution to become about 1 percent more unequal than the before-tax income distribution. A simulation model suggests that itemized deductions will continue to be regressive despite their cut-back for high-income taxpayers. Conversely, personal and dependency exemptions and standard deductions together contribute more to overall progressivity and to diminishing income inequality than does the tax rate schedule. Credits as a whole make a modest incremental contribution to overall vertical equity.

 Additional Evidence of Year-End
Tax-Motivated Trading by Individual
Investors, 1962-1986

Paul R. Koogler and Edwin D. Maberly


The "January effect" refers to the phenomenon that risk-adjusted January returns are unusually large for small firms. Prior studies of year-end tax-loss selling and the January effect lack a control for institutional trading. This study extends prior research and excludes the effects of institutional trading by using a unique data set, the average daily transaction prices for New York Stock Exchange odd-lot sales. Dividing the average daily transaction price of odd-lot sales over the "last half" of December by the average price over the "first half" of January forms the DEC/JAN ratio. This study addresses (1) whether the DEC/JAN ratio behaves as a proxy for the intensity of year-end tax-motivated trading by individual investors and (2) whether the DEC/JAN ratio and the January effect are positively related. For the 1962-85 year-ends, the DEC/JAN ratio exhibits a pattern consistent with tax-loss selling by individual investors of increasing intensity as the end of December approaches. At the year-end 1986 just prior to the elimination of the long-term capital gain deduction, the DEC/JAN ratio captures gain realization in December by individual investors. Using the DEC/JAN ratio as a proxy for the intensity of year-end tax-loss selling, this study provides evidence that tax-loss selling and the January effect were positively related during the 1962-85 period. However, the data of this study are not inconsistent with prior research that found evidence that the January effect may also be attributable to events other than tax-loss selling.

 Determining the Substitution Rate Between
Incentive Stock Options and
Non-Qualified Stock Options

 Haim A. Mozes


This paper develops a multi-lateral tax model that can be used to determine (1) the number of non-qualified stock options (NQOs) that will have the same after-tax cost to the firm as one incentive stock option (ISO), and (2) the number of NQOs that will provide the grantee with the same after-tax value as one ISO. The model is based on a characterization of the grantee's optimal behavior when the options grant is not completely hedged or diversified and the grantee is therefore not compensated for bearing the underlying stock's unsystematic risk. A key result of the model is that the tradeoff between ISOs and NQOs that the firm can offer and the minimum number of NQOs that the grantee will substitute for one ISO are functions of the grantee's ability to hedge or diversify the underlying stock's unsystematic risk. An application of the model provides a multi-lateral scenario in which some employees will select ISOs even after the Tax Reform Act of 1986 (TRA86), despite the fact that TRA86 resulted in a higher tax rate on corporate income than on personal income. Another application of the model provides a multi-lateral scenario in which, after TRA86, some employees, but not all, of a given firm disqualify their ISOs in response to incentives provided by the firm. The scenarios occur when the firm's stock has substantial unsystematic risk and its grantees bear different amounts of that risk.

The Use of Life Insurance in Estate
Planning: Additional Evidence

Terry L. Crain


This study uses cross-sectional regression analysis to examine the relation between life insurance coverage and liquidity for individuals who anticipate having taxable estates. The results indicate that there is a negative relation between the amount of life insurance an individual owns and the amount of liquidity (exclusive of the life insurance) in the anticipated estate. This finding supports the hypothesis that individuals who anticipate having taxable estates, but lack the liquid assets to pay the estate taxes, will fund this need with life insurance. This study also finds a negative relation between the amount of life insurance owned by an individual and the individual's ability to defer the payment of estate taxes. Finally, the results show that individuals carry more life insurance than necessary to pay estate taxes, administration expenses, and debts.

 A Study of the Effectiveness of Writing
Exercises as Elaboration Techniques
for Teaching Tax

 Peggy A. Hite and Robert W. Parry


Based on self-elaboration theory, this study examines whether comprehension is better when tax students are asked to provide a written explanation of the rule that underlies an illustrative example rather than when the rule and example are jointly presented by the instructor. A second elaboration experiment examined whether comparative elaborations increase comprehension relative to the written explanations of separate concepts.

Rule application problems were given to students immediately after instruction, a few days later, and at the end of the semester. To test for potential intervening effects, grade point average and overall course performance were statistically controlled. The results indicate that written self-elaborations were found to be a useful teaching methodology, but the results were sensitive to the student's level of academic achievement in the course. Self-generated written analyses tended to help students with higher academic achievements. In addition, these students performed better when they were asked to write a set of comparative rules rather than several separate rules. The implication for educators is that written self-elaborations provide a means for discovery learning that will help achieve the goals of learning-to-learn and learning-to-write. Although the benefits of this strategy were associated with the higher ability students, future research should explore whether repeated exercises in self-elaborations can improve the lower achiever's ability to think inductively.