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Tax-Refund System Hinders Savings in U.S.

Tax refunds seem to reduce workers’ financial security by encouraging them to spend money rapidly instead of building their savings.

Every spring, Americans reconcile their taxes, determining how much they actually owed to the Internal Revenue Service and how much they paid throughout the previous calendar year. Typically, Americans pay more taxes than they owe. The IRS says it sends refunds to more than 80% of taxpayers, averaging around $2,800 per refund. Although Americans may enjoy the moment when they get their refund, does lending money to Uncle Sam (at no interest) throughout the year and collecting it every spring hinder workers from achieving their financial goals?

After examining data from Morningstar’s HelloWallet division, I have come to the conclusion that the tax-refund system hinders Americans’ ability to achieve their financial goals. Guidance on how to effectively allocate refunds could be enormously helpful for many U.S. workers.

What People Do With Their Refunds
For my research, I analyzed HelloWallet user data to investigate spending before and after users received their 2014 tax refunds.

HelloWallet is a financial application that helps people understand their finances by aggregating data from credit cards, checking accounts, and investment accounts. Companies that subscribe to HelloWallet distribute it to their workers as a benefit. HelloWallet members are a little younger and earn a higher income than the general public, so the results I found may not be completely representative of the U.S. population. (Workers in our tax-refund sample have a median income of $75,000 as opposed to around $50,000 for households in the United States; most workers in our sample are younger than age 50.)

Nonetheless, our study of this group reveals interesting behavioral insights and complements existing work on tax refunds.

I examined three possible ways people could deploy their tax refunds: 1) use the money to pay down debt (including paying noncurrent bills), 2) save the money, or 3) spend the refund.

About 25% of our sample used it to pay down credit-card bills, and those payments were quite high. For these workers, I saw average credit-card payments go up $2,000 in the month after they received their tax refunds. This suggests that some workers would benefit from better aligning their withholdings to their actual tax burden, so they could avoid taking on debt throughout the year. Of course, some workers may be unable to resist the temptation of spending the extra money and continuing to take on credit-card debt.

Only about 37% of workers saved their tax refunds, which seems very low from a rational economic perspective. Indeed, financial economists would argue that people should want to smooth their consumption over their lifetime, and certainly their consumption over the year. Saving their refund is a simple way for investors to raise their lifetime income.

A License to Spend
Instead, people tend to spend the money relatively quickly. People’s spending increased in every category that we track in the HelloWallet application after they received their tax refunds.

Indeed, our data suggest that workers regard tax refunds as a windfall that entitles them to spend. Spending increased for nondurable purchases such as transactions labeled clothing, entertainment, travel, personal care, restaurants and bars, and even groceries. I also saw in the data increases in cash transactions and spending on durable goods, as well as the increases I mentioned earlier in credit-card payments and bill payments.

In addition to giving people a license to spend, some taxpayers clearly used their refunds to spend big. Indeed, about 38% of workers used refunds at least in part to make unusually large purchases. This may be one of the most rational uses for tax refunds if people do not trust themselves to save. For someone who is overwithholding, it’s the perfect “forced savings” device.

A curious thing I saw in the data was that the larger the refund, the more of it workers tended to spend, which is not consistent with some behavioral economic theories. This finding held even for people who are not liquidity-constrained. People who could have spent money on a big-ticket purchase (or on a nice meal at a restaurant) still waited until they had their refund in hand to do so. This gives us more evidence that the refunds gave people a license to spend. Another explanation might be that taxpayers “mentally account” for tax refunds differently, allocating them to a bucket of money that can be spent with no guilt.

Refunds as Regular Income
So, what does all this mean? According to my research, tax refunds seem to reduce workers’ financial security by encouraging them to spend money rapidly on nondurable goods instead of building their savings. By reducing the value of each paycheck, over-withholdings also may increase the likelihood that workers will start to accrue credit-card debt. In sum, many workers could reduce interest payments from credit-card balances and bolster their retirement savings by reducing their tax withholdings. For example, workers could reduce their withholdings and allocate the extra income to a 401(k).

Advisors and employers should provide more counsel around tax refunds to try to get workers to think of their refunds as regular income and, if they don’t need to spend it immediately, to allocate it for long-term goals.