Refunds don't always help lower-income taxpayers
Getting a tax refund from the federal government at the end of the year may not always be the best option for lower-income populations, according to the research from Harris School economist Damon Jones.
About 80 percent of Americans who file taxes receive money back鈥攊ncome that was over-withheld throughout the year鈥攕aid Jones, who studies the intersection of public finance, household economics and behavioral economics. On average, the IRS estimates that taxpayers who receive these refunds get back about $1,000 every year. That average is about $3,000 this year, thanks to temporary stimulus efforts.
Getting that cash back might be a pleasant surprise to affluent demographics, but Jones鈥檚 latest research suggests that those refunds may not always be helpful to lower-income populations. After studying why the majority of taxpayers typically choose high withholding rates, he found that U.S. tax policy predisposes many poor families to receiving a one-lump sum when they may have been better off receiving that money throughout the year.
鈥淔or people who have money in the bank in a savings account, that cost is very small because in the case of an emergency, you have other sources of money,鈥� he said. 鈥淏ut if you鈥檙e living paycheck to paycheck, your only alternatives may be to borrow on a credit card and pay interest after the fact.鈥�
The current U.S. tax system was adopted in the 1940s to help pay for World War II, when the government implemented a pay-as-you-earn tax system that favors overpayment. 鈥淚t actually increased compliance,鈥� Jones said. 鈥淚f you have to file your taxes to get some money back, you鈥檙e more likely to share information about your earnings.鈥�
There are a number of reasons why many taxpayers don鈥檛 mind overpaying, he added. For one, it can lessen the risk of having to owe the government money at the end of the year. Other supporters see over-withholding as a forced saving mechanism that takes money out of the paychecks of people who would otherwise spend it. 鈥淥ne check is very salient,鈥� Jones said. 鈥淎n extra $20 a week perhaps falls through the cracks and falls into the cash register.鈥�
But there鈥檚 also a more passive reason this happens, Jones argues in a recent working paper: inertia. Looking at four separate case studies, he concluded that tax policies in the U.S. generally push individuals toward overpaying and getting a refund at the end of the year. For instance, if a new employee doesn鈥檛 fill out his or her W-4, the employer will designate zero allowances for them, which will likely result in an income tax return. Another example could be that someone who has children might not update their withholding status immediately, and therefore get a larger tax credit back at the end of the year.
By waiting for this return, Jones is concerned that lower-income populations are essentially giving the government a zero-interest loan with money that they could be spending. Many even take out and pay interest on 鈥渞efund anticipation loans鈥� that predict how much they will get back from the government if they need it sooner.
Figuring out how many over-withholders fall into that category and exactly how detrimental it is to their financial livelihoods is the challenge of Jones鈥檚 forthcoming research鈥攈e expects to have preliminary findings later this year. 鈥淲e can鈥檛 assume that just because everybody is getting refunds, it鈥檚 because they鈥檙e better off with refunds,鈥� he said. 鈥淭here are people who prefer this, but it鈥檚 dangerous to jump to the conclusion that this is everyone鈥檚 preference.鈥�
Provided by University of Chicago
