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Expensive Tax Refunds
- Brookings Institution Press
- Chapter
- Additional Information
204 The U.S. federal income-tax code has an enormous potential to shape the economic and financial decisions of tax-paying households. Tax rates, compliance laws, and the withholding system all create incentives, as do the methods by which the U.S. Treasury collects tax receipts and disburses tax refunds. The role of third-party service providers in the tax system is less well understood, even though tax preparation firms have a prominent role in the U.S. tax system. Nationally, more than half of taxpayers use paid preparers to submit their tax returns. Low- and moderate-income (LMI) households are among those who use the paid tax preparation system. In fact, among low-income households who file, more than two-thirds use paid tax preparation services. Thus understanding the role of third-party providers in the tax system is critical to understanding how our tax system affects low-income households. Tax preparation service providers can potentially both help and hurt taxpayers . On the positive side, tax preparation firms may increase the likelihood that taxpayers will hear about and take advantage of tax incentives designed to reach them. For example, over 20 million low- and moderate-income households file for approximately $35 billion in refunds and reduced tax liability under the earned-income tax credit (EIC), designed to reward work by low-income taxpayers. On the negative side, tax preparation firms can add to the efficiency costs of the tax system and reduce the amount of redistribution through the EIC and other tax credits and expenditures. Furthermore, tax preparation is a highfee service in itself, and low-income households often face additional, ancillary Expensive Tax Refunds michael s. barr and jane k. dokko 9 expensive tax refunds 205 fees associated with filing. For example, many low-income households lack bank accounts and may also pay a nontrivial fee to cash their government refund check at a check casher or other establishment. In addition, a large portion of households receiving the EIC take out costly refund anticipation loans and similar products in order to receive the proceeds of their tax refund more quickly or to pay for tax services. Understanding the institutional context in which tax-refund distribution occurs, including households’ attitudes toward the withholding system , is important for understanding the efficiency and distributional aspects of the tax system. In this chapter, using data from the Detroit Area Household Financial Services (DAHFS) study, we examine the tax-filing experiences of LMI households. The study documents households’ current tax-filing behavior, their attitudes about the withholding system, their use of tax refunds to consume and save, and the mechanisms by which they would like to receive their refunds. Overall, there is little empirical evidence on the tax-filing experiences of LMI households. Toward this end, the study documents the prevalence of the use of tax preparation services and the receipt of both tax refunds and refund anticipation loans (RALs). It describes the reasons taxpayers cite for taking out RALs and the uses to which they put their tax refunds. Using individuals’ responses to a hypothetical scenario in which individuals choose the time profile of how they pay their taxes and receive their refunds, this chapter begins to explore the extent to which households use the withholding system as a financial planning tool. The evidence on LMI households’ tax-filing experiences helps to shed light on a number of important policy questions. For example, our analysis informs the policy debate over tax complexity (Holtzblatt and McCubbin 2004; Barr 2004; President’s Advisory Panel on Federal Tax Reform 2005). In addition, our evidence helps to assess whether households’ overwithholding, use of paid tax preparers, and use of refund anticipation loans is better understood through rational-actor models or through behavioral economic lenses. In particular, we begin to explore whether default rules, framing, and heuristics play a role in LMI households’ tax-filing behaviors (Thaler 1990). Moreover, our analysis can assist in the formulation of consumer financial protection regulation and national savings policies. Policy Context and Previous Research Paid tax preparers provide valuable services to taxpayers but charge high fees, leaving the net benefits ambiguous. On behalf of households facing conflicting and complex rules under different tax provisions for determining household status and dependents, tax preparers interface with the tax code. They also serve households who worry about increased Internal Revenue Service (IRS) audits (particularly among EIC filers) and IRS delays in receiving their refunds [3.236.145.110] Project MUSE (2024-03-28...