The ongoing flap over tax refunds has once again highlighted a serious issue: Americans use tax withholding from their paychecks as a major savings tool. They give the government more than they owe in income tax throughout the year just so they can get a check the following spring. For many low-income filers, overwithholding has become their preferred, and perhaps their only, way to save. They ought to have a better option. 

Traditional economists say deliberately having too much tax withheld is, not to put too fine a point on it, nuts. It is, for those of us old enough to remember, Uncle Sam’s version of the neighborhood bank’s Christmas account. But the Treasury doesn’t even give you a toaster.

Instead, many of us give the US Treasury our money, earn no interest, and—often—use our tax refund to pay off debt we’ve incurred over the course of the year. Loans on which we may have been paying 14 percent interest or more.

“It feels good”

The size of this phenomenon is stunning. In 2017, the IRS issued almost $437 billion in refunds to about 122 million households—more than two-thirds of all filers. It refunded about $383 billion in individual income taxes and paid an average refund of almost $2,700. Households making less than $50,000 received one-quarter of all refunds, or about $100 billion. Some came from refundable tax credits but plenty was excess withholding.    

So why do we do it? It feels good to get that check every spring—certainly better than writing a check to the IRS. According to one survey, 80 percent of low- and moderate-income tax filers explicitly say they consider overwithholding a savings tool. For many Americans, especially those who do not have bank accounts, there appears to be no better way to save. And that is a problem.

For years, state and federal policymakers have tried to encourage people to save for specific goals—primarily retirement, education, and health care. Most, such as IRAs, 401(k)s, 529 accounts, and Health Savings Accounts, rely on tax subsidies to encourage us to save.

Low participation

In addition, about half of employer-based defined contribution plans, such as 401(k)s, have adopted automatic enrollment, a feature that substantially increases participation. Some employers match worker contributions.

In 2016, about 80 percent of eligible workers participated in their 401(k) plans. Yet, overall participation and balances remain dangerously low, especially for low-income workers. For example, in 2016, only about one-quarter of those in the lowest-income 20 percent of households had a 401(k), and their median balance was a paltry $26,700.

In recent years, the government has taken still-more steps to encourage workers to put aside some of their paychecks.

Lack of interest

For example, the Obama Administration tried a program called MyRA. The idea: Create a simple savings vehicle for low-income people. They could contribute as little as $5 per pay period into a Treasury-bond-like interest-bearing account. Once the account reached $10,000, it would be converted into a standard Roth-type IRA.

It died of lack of interest.

Savers with incomes of up to $32,000 ($64,000 for joint filers) are eligible for an income tax credit as high as $2,000 to help offset contributions to their retirement savings. But the savers credit isn’t refundable, so does not help many low-income households. And only about a quarter of those who were eligible claimed the credit in 2014.

Recently, five states announced plans for their own automatic savings plans for workers without access to a 401(k)-type plan. Called Auto-IRA, it allows participants to have some wages automatically deposited in pooled, privately-managed accounts.

A lottery  

But retirement accounts require savers to hold the money for years, and for a specific purpose. That fails to satisfy what appears to be a deep psychological need to get an annual check. What to do?

The government could turn excess withholding into a more explicit savings vehicle by paying modest interest on, say, the first $1,000 of overwithheld taxes. That would provide a small reward for saving. Plus, it seems equitable since taxpayers owe interest—and penalties—if they are underwithheld by too much during the course of the year.

Another alternative is a foundation-funded project called SaveYourRefund. Since 2013, it has encouraged people--especially low-income non-savers—to put aside at least part of their refunds. One tool: an extra behavioral nudge: Those who participate are entered in a lottery with a chance to win a cash prize of $100 (two filers win a prize of $10,000).

The program works with some locations of the Volunteer Income Tax Assistance (VITA) program, which helps many low-income households file their tax returns. Since 2013, about 15,000 participants saved about one-third of their refunds, or about $13 million. Last year, participants saved an average of about $850. Unfortunately, we know relatively little about how they use the money.  

Relative to the more than $100 billion in refunds received annually by those making less than $50,000, this initiative barely registers on the radar screen. But the sponsors are on to something: Acknowledge that people want their refunds, and figure out a way to get them to save at least a fraction of what they get back from the IRS.