Tax time is a stress on family finances. It requires many of us to sum up our finances and fill out a myriad of forms by April 15th (or April 18th this year). But the process of filing a tax return is only half the stress. The actual financial transaction of receiving a tax refund or making a tax payment is often the single largest financial transaction families experience in a given year and a significant contributor to financial volatility.
The JPMorgan Chase Institute recently analyzed the financial impacts of tax time using an anonymized sample of core Chase checking account customers, and this yielded a surprising insight: on average, tax payments and tax refunds are even larger in magnitude than the absolute change in income individuals experience when they gain, lose or switch a job (Figure 1 below). Tax payments and refunds explain a significant amount of the volatility in income and spending on an aggregate basis (Figures 2 and 3 below). This volatility matters because it is hard to manage.
Tax payments, which often represent a large portion of individuals" incomes, can be difficult for people to make. Even if we assume only families in the top two income quintiles make tax payments, a tax payment of $4,732 represents almost 4 percent of total income for these families, and they have to pay it out in one go.1
The rapid growth of the Online Platform Economy and alternative work arrangements more generally further complicate this story. Labor platforms, such as Uber and TaskRabbit, tend to attract lower income individuals, and these employment opportunities do not typically withhold taxes from take-home pay. As a result, more low- to middle-income individuals might find that they have to make tax payments and might even owe tax underpayment penalties. Innovations to predict and automatically withhold or save taxes owed could help contingent workers avoid owing significant payments at tax time.
Even tax refunds are stress-inducing, however. With an average refund for all tax filers of $2,733 in 2013 and a maximum EITC refund of $6,143 for a family with three or more dependents, tax refunds are often the single largest lump-sum payment that households receive all year. According to 2013 tax year data and the Consumer Financial Protection Bureau (CFPB), 79 percent of tax filers received a tax refund—including 27 million households who received the Earned Income Tax Credit (EITC) and 85 percent of households with incomes less than $50,000. Many used the extra cash to pay for school, replace a home appliance or even take a vacation. But a recent study showed that low- and middle-income families spend less than half (43 percent) of their tax refunds within the next six months. They save 57 percent of their tax refund, using 43 percent to pay down debt and otherwise saving the remaining 14 percent. Not surprisingly, individuals with more unsecured debt were significantly less likely to save any of their tax refund.
These statistics are striking for two reasons. First, they suggest that people need the money they receive from tax refunds to cover their daily expenses. And, it is important to note that if individuals had access to those funds at more regular intervals, they might be able to mitigate their debt obligations.
Second, these statistics indicate that, despite the debt overhang, saving at tax time is a major opportunity: for the average individual who saves 57 percent of their tax refund, that represents over $1,500 of savings. To put this number into perspective, we found that median income households fall $1,800 short of the $4,800 liquid asset buffer necessary to withstand 90 percent of the adverse income and spending shocks they experience, and households in the lowest income quintile are $1,000 short of the $1,600 liquid asset buffer they need. At a time when real wages have been in decline and income volatility has been increasing for most workers, tax refunds are a great opportunity for many low- to middle-income families to start—and maintain—a level of savings that could provide a lifeline to weather financial storms.
It is one thing to demonstrate the opportunity to save, but it is quite another to encourage people to put money aside. To that end, a number of innovative public sector and nonprofit programs, neatly summarized in a toolkit, encourage families eligible for the EITC and other low- to middle-income recipients, to save rather than spend their tax refunds. But getting people to save their tax refund has proven difficult. Even in successful programs, participation rates are often low and the size of the impacts often small, especially given the amount of resources dedicated to changing behavior.2
While behavioral economists and nonprofits work together to identify the most effective ways to encourage tax-time savings, it is also important to consider alternative paths. Why not reduce the volatility by paying out tax refunds in installments rather than in a lump-sum payment?
Two notable proposals already exist along these lines. The Corporation for Enterprise Development (CFED) has proposed a nudge in this direction with their Rainy Day EITC, whereby individuals can elect to receive 20 percent of their EITC payment six months later, with a 50 percent match. Similarly, the Center for Economic Progress piloted the Chicago EITC Periodic Payment Pilot, in which individuals received half of their estimated EITC refund in four payments during the EITC tax year. They found that 90 percent of individuals who received the periodic payments preferred them over a lump sum.3 Moreover, individuals who received regular payments accumulated less debt; paid fewer late fees; and, most importantly, experienced lower financial stress.
Instructively, it is worth noting that the Advance EITC, in which individuals could receive a portion of their EITC in every paycheck, was eliminated with the passage of the Education Jobs and Medicaid Assistance Act of 2010. An analysis of the program documented that only 3 percent of eligible individuals had opted into this program and that compliance with program requirements was low. Key lessons and design questions emerge from this failed experiment. Should we make periodic tax refund payments the default option for individuals with an opt-out option? Should the periodic refunds come during or after the tax year? Should all or some people be eligible for periodic installments? Should there be a savings incentive attached? A simple opt-out program to pay tax refunds in installments could give four-in-five families a substantial, recurring income stream that might be a promising way to get low- to middle-income earners on a path to greater financial resilience.
The JPMorgan Chase Institute is committed to delivering data-rich analyses and expert insights for the public good. Our reports, Weathering Volatility and Paychecks, Paydays, and the Online Platform Economy, highlight the demographics and sources of income and consumption volatility and how Americans are prepared to weather these changes.