Small Business Tax Compliance under Third-party Reporting

How does third-party income reporting affect tax compliance? We use confidential administrative data from tax returns and information reports to estimate the impact of third-party income reporting on small business tax compliance. Since 2011, payment settlement entities (e.g., American Express) were required to report payment card transactions to both the firm and the Internal Revenue Service using Form 1099-K. This requirement made businesses’ receipts from payment cards—but not their cash receipts—third-party reported. Consequently, businesses located in higher payment card use areas experienced greater levels of third-party reporting than businesses located in lower credit card use areas. We construct an index of payment card use at the commuting zone level and we use this variation to identify the effect of Form 1099-K on reported receipts and deductions by small businesses. Overall, we find that the legislation modestly increased reported receipts without significantly increasing deductions. We also find substantial heterogeneity, with smaller firms, firms in business-to-consumer industries, and partnerships reporting a relatively large increase in receipts and a partially offsetting increase in deductions, implying a modest increase in tax compliance.