Thesis: Contrary to popular opinion, the government should not pay interest on tax refunds.
The common adage says that only two things in life are guaranteed: death and taxes; so today being tax day, it only felt natural to write about taxes. As I have gotten further into my study of finance, it is clear to me that there are many factors, both intentional and unintentional, that are the result of taxes. One interesting, potentially unintentional, result of government taxes and tax refunds is the zero interest rate that you receive on your refund. When the government “borrows” your money and then pays you back, a rational investor would argue that they should be paying you for the use of your funds. The government argues differently. And while many are upset about the government’s zero interest rate, it makes sense in the large taxation scheme.
The outline of the argument over the potential losses that tax payers face with zero tax interest rates was outlined in the recent US News article Excited About That Big Tax Refund? Think Again. Abby Hayes discusses why getting a big refund, which for 2014 was $2,847, might not be such a good thing:
In fact, when [the government] writes that fat refund check, the agency is just giving you money back it owes you. In other words, when you get a massive refund, it means you’ve loaned the government money from your paychecks throughout the year. And the government is not paying it back with interest!
Clearly the interest on tax refunds can be sizable, especially when you consider the return of the S&P 500 as an investment alternative. But the question falls to who foots the bill if you were to offer interest back on tax refunds. Two alternative answers follow: the government provides the refund itself or there is no tax withheld (and thus no refund to follow).
A FiveThirtyEight titled Don’t Be So Happy About That Tax Refund provides an analysis of why psychologically the second option would not work:
Getting a government check in the mail (or direct-deposited into your bank account) feels like a windfall. For many people, their annual refund amounts to a savings plan: A third of respondents in the Bankrate survey said they planned to save or invest their refunds.
People seem to be happy with the windfall that they receive from the government, acting as it was an unexpected bonus that they receive, even if it was their own money. In the same sense, there would probably be equal grumblings over the need to pay these taxes every year. If your employer/the government did not withhold some of your income, you might be able to invest these extra savings, but you would have to deal with a significant tax bill every April 15, which could be a painful and potentially credit threatening event (if the taxes were not saved for previously and it results in an inability to pay).
To respond to the first answer (the government pays the interest to you), you have to think of the tax market in current equilibrium. If the government is currently “borrowing” from individuals at a rate that funds enough of their financing throughout the year on an equilibrium basis, making the government pay interest on their borrowing would just cause the government’s “cost” basis to increase. The government, with the monopoly power in the tax market, would simply pass these increase costs along to the individuals paying taxes. What follows is that, as the government pays you more for the interest on your tax refund, your tax bill would increase, which should equilibrate out to a zero change for individuals.