Service Fees

Poor people pay for quick access to free money.

Imagine that it's tax season, the period between February 1 and April 15 when W-2 and 1099 forms start appearing in the mailbox and the dread starts. A low-income resident of Washington, D.C.–let's call her Sara–gathers her documents and walks to her neighborhood tax preparer. She knows of the shop because she passes it on her walk to work. Besides, it's been blanketing her neighborhood with fliers, and a couple of her friends used it last year and got their refunds weeks before she did. Sara provides the preparer with her W-2 and he fills out her 1040a and D.C. tax forms, which costs $90. For $12 more, Sara decides to file the paperwork electronically, which will reduce her wait from six to two weeks. The preparer offers to advance her the $1,500 refund in three days for another $88.00. Sara agrees and three days later she's taking her two children to pizza and a movie, buying herself a new dress, and paying off some credit card debt.

Many people would view this transaction as a success. Services were provided–tax preparation, electronic filing, and a cash advance–and fees were paid. Yet for D.C. think tankers pondering the lives of the poor, this is yet another problem for the government to solve. The Brookings Institution and the Progressive Policy Institute have just released a study that tries to make this case.

Why, one might ask, is a low-income person overpaying taxes by $1,500 a year? How did she even put herself in the position of needing her money back? Answer: She's not, and she didn't. The $1,500 isn't really a tax refund; it's a government payment known as the Earning Income Tax Credit (EITC), which has grown into the dominant way the federal government provides cash assistance to low-income Americans. Millions of people who owe no money to the government nevertheless receive significant checks from the IRS.

The catch is that they have to deal with the tax system. The paperwork is relatively complicated. And so an industry emerges and expands to serve it.

The Brookings/PPI paper examines finds that tax preparation services are popular among Americans, especially those eligible for the EITC. (One in two Americans purchases assistance at tax time, while 68 percent of those eligible for the EITC do.) Tax preparers blossom like perennials during tax season and do so disproportionately in neighborhoods with high concentrations of EITC-eligible households. They do so because it's a profitable and growing business, especially the short-term loans. "An estimated $1.75 billion in EITC refunds in 1999 was diverted toward paying for tax preparation, electronic filing and high cost loans," notes the study. "In 1999, nearly half of the $30 billion in EITC claimed nationwide was refunded through high-priced loans."

It's a strange world in which offering a product that's popular becomes proof of one's guilt and a problem to be solved. Because low-income Americans are willing to spend money to get free money quicker–and save the headache of filling out tax forms in the process–it's assumed that there's a heist in progress. This same logic would be considered absurd if it were applied to middle- and upper-income Americans, who pay for financial services all the time. And it isn't even a complete picture of the EITC situation.

The real story there is how riddled with fraud the program is. In that same year that $1.7 billion of taxpayer money was supposedly diverted to preparers, a study by the U.S. Treasury estimates that the government overpaid by up to $10 billion. (This is nearly a third of the total disbursement, and it is the reason low-income taxpayers are audited–that is, sent a computer generated letter–at higher rates than high-income Americans.) A full accounting of the money "diverted" from the program would factor in the amount of cash, if any, that professional preparation saved the taxpayers in false claims.

Other problems plague the effort to account for this money as diverted. As the study notes, but doesn't dwell on, the firms' very presence advertises the availability of the EITC and may, in fact, prompt people to claim it who otherwise wouldn't. Even the "high-priced" loans may beat the next best alternative, which is turning the promise of a refund into immediate cash at a pawnshop or in the informal sector.

There is a solution to this diversion problem. The IRS can speed up its electronic refunds from the current two weeks to three days. H&R Block, the leading EITC tax preparer, plans to end its loan business in 2005 when the IRS is scheduled to have a quicker system in place. Until then, the market will continue to turn government failure into private profit.