If Congress Offers You This Tax Advance, Beware

(Bloomberg Opinion) -- Sometimes economists suggest things that make sense in theory, but don't work in the real world. Take the child tax credit, which has been getting a lot of attention lately as lawmakers argue over how to expand its benefits in the pandemic-relief bill.

Congress is poised to offer families some of their credit payments in periodic advance checks instead of making them wait for their once-a-year tax refunds. The idea is to ease Covid-related economic pain and give the economy a boost. The reality? It could easily backfire.

Right now, families can receive up to $2,000 per child, less for married couples earning more than $400,000. Many middle- and higher-income families effectively get the credit periodically in the form of less taxes withheld from paychecks. Lower-income families with smaller tax liabilities tend to get the credit as an annual lump sum payment included in their tax refunds.

A provision in the version of the pandemic legislation approved by the House of Representatives last month would bump the payment to as much as $3,600 for children under six and $3,000 for those between six and 17 for one year (but lawmakers say the goal is to make the change permanent). In addition, half the credit would be paid in smaller amounts periodically, unless people opt out.

Supporters of periodic payments say that distributing less money more frequently is ideal because lower-income families often experience bigger swings in income from month to month. A monthly payout would help them meet monthly expenses such as rent, reducing the reliance on payday loans and the like.

That may be true for some people, and parents should certainly have the option to choose monthly payments, especially amid the pandemic. But getting a tax refund is something Americans look forward to and want, regardless of income. If taxpayers are automatically defaulted to a monthly payment, there could be some pitfalls.

No more mini-splurges

A study a few years ago of recipients of another payment, the earned income tax credit, showed that there's an important psychological component to getting a lump-sum payment. It gives taxpayers the flexibility to do something for themselves or their families that they wouldn't ordinarily do, like splurge on a toy or go to a special dinner. We're not talking about big spending — the study by sociologist Jennifer Sykes and others said that only about one in $10 from the tax refund was spent on these so-called treats. But interviews with the EITC recipients indicate that the purchases mean so much more than their dollar value: “These allocations make people feel they are part of the mainstream, instead of just watching from the sidelines,” the study said.

Loss of savings

The same study also found that annual payments are essential for creating or increasing savings. Parents said they couldn't substantially build savings at any time other than tax-refund season. And there's another intangible benefit, too: the idea of using a refund to work toward a financial goal motivates people and helps with future planning.

Taxpayers could theoretically just save their periodic payments and turn them into a lump sum, but human nature prevents many from doing so. Work by Nobel-prize winner Richard Thaler and others shows that there are all kinds of psychological barriers to rational financial decision-making.

I called Nina Olson, who served as the watchdog at the Internal Revenue Service for 18 years, helping millions of taxpayers with their returns and refunds. She confirmed that the IRS ends up being a de facto savings bank for many low-income taxpayers, who would have a hard time accumulating savings without their refunds.  

Overpayment

Some taxpayers could even wind up owing the IRS money if child-tax-credit payments were made in advance. To be eligible for the credit, a child generally has to be living with the recipient for at least six months. Family situations often change from year to year, so just because someone received the credit last year may not mean they still qualify. Other countries that make periodic payments, such as the U.K., Australia and New Zealand, have had to deal with overpayments, in part because of family changes.

The House bill sets up a safe harbor, saying that single filers making up to $40,000 wouldn't owe anything for overpayments, but others making more could owe a portion or the full amount, depending on their incomes. The $40,000 threshold is helpful, but there are still many families that could get caught.

Keep an eye on what happens with the safe harbor cutoff as the bill makes its way through the Senate, along with whether lawmakers decide to stick with periodic payment of the credit. Expanding the child tax credit is one of the best ways to help fight child poverty, and when given as a lump sum, there are psychological benefits, too. Give parents their advances, if that's what they want, but don't be too pushy about it.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Alexis Leondis is a Bloomberg Opinion columnist covering personal finance. Previously, she wrote about personal finance, asset management and mortgages, and oversaw tax coverage for Bloomberg News.

©2021 Bloomberg L.P.