Economic Analysis: Will Disappointing Refunds Derail the TCJA?

In these uncertain times, meaningful predictions were never in higher demand or thinner supply. Will the economy continue to grow in 2019? Which party will prevail in the 2020 election? By how much, if at all, will the Tax Cuts and Jobs Act be modified in 2021? In a few months, one fact will emerge from fog that will help answer all these questions: the amount of individual tax refunds issued by Treasury for tax year 2018, the first year the TCJA was in effect.

At this point, the prediction of that amount itself is difficult. A good deal of partisan bickering is being generated by early IRS reports that, despite the tax cut, the average refund paid in 2019 through the week ending February 8 declined to $1,949 from the average of $2,135 for the comparable period in 2018, an 8.7 percent drop. Total refunds declined from $28.9 billion to $22.1 billion, a 26 percent drop. But those amounts are based on only 11.4 million refunds out of about 100 million refunds expected, as hard-pressed Treasury officials try to point out. (See figures 1A, 1B, and 1C.)

Treasury also tried to explain that when it comes to the benefits to taxpayers from the TCJA, refunds are only part of the equation. Arithmetic tells us:

So for example, if withholding by an employer (using withholding tables issued by Treasury in January 2018) has been sufficiently reduced, a taxpayer might have received a significant tax cut compared with the prior year, even if his refund in 2019 is lower than what he received in 2018. The potentially monstrous political problem facing Republicans is that taxpayers may not have noticed a reduction in withholding in their paychecks but will notice a reduction in their refunds. For example, if Jane Taxpayer got a $520 tax cut because of the TCJA, she may not have noticed that federal withholding in her biweekly paycheck was reduced by $30 (a total of $780 for the whole year). But she might notice her refund decreased by $260 ($780 minus $520).

There are two levels of apparent innocence, and they are painful to observe. First, there are taxpayers who should reason that smaller refunds actually benefit them. It means they are providing less interest-free lending to the federal government. But most taxpayers are humans with significant math and tax anxiety. Busy with nontax aspects of their lives, they simply don’t take the time to understand this.

Second, and even worse, there are the Treasury officials who are trying to explain why taxpayers should not be disappointed by smaller refunds when in fact taxpayers will be disappointed with smaller refunds. It’s like telling a child that sugar-coated walnuts in the dinner salad were his dessert. No chocolate cake for you. As the old saying goes, in politics, when you are explaining, you are losing. And boy, is this Treasury explanation a loser.

Too Little Withholding?

Now it’s very fuzzy, but all indications are that Treasury did reduce withholding. When the new withholding tables were released just weeks after passage of the TCJA, Treasury said the new guidance “was constructed to work within the constraints of the existing payroll withholding system in order to deliver the benefits of the tax cuts as soon as possible, to as many Americans as possible, and with as little disruption as possible.” (Prior coverage: Tax Notes, Jan. 15, 2018, p. 295.) That sounds like less withholding.

A July 2018 study by the Government Accountability Office reported that Treasury estimated that the percentage of taxpayers with wages overwithheld (by more than $100) would decline from 76 percent to 73 percent and that the percentage of taxpayers with wages underwithheld (by more than $100) would rise from 18 percent to 21 percent. Just recently in a February 14 conference call, a Treasury official said, “We do expect fewer taxpayers to get refunds this year than received them last year.” (Prior coverage: Tax Notes, Feb. 18, 2019, p. 822.)

Finally, we now have available hard data shown in Figure 2. Withholding at $1.302 trillion in 2018 was in fact lower than the $1.349 trillion amount for 2017, a decline of 3.5 percent. That is about 8.5 percentage points below what you would expect in an economy that in nominal terms grew by 5 percent over that period if there were no change in law or withholding.

But — and here is the critical question — did Treasury reduce withholding so much that refunds in 2019, either the number, the total amount, or the average amount, will be down compared with refunds in 2018 when the tax season is over in May? As noted, if the first 11 percent of refunds is a representative sample, the answer is yes. If this trend continues, it spells trouble for the economy, for the Republicans, and for the durability of the TCJA. The latest polling from Gallup in September showed that despite estimates that 80 percent of taxpayers will receive a tax cut and only 5 percent will receive an increase, the public approval/disapproval ratio of the TCJA is 39/46 percent.

If the economy doesn’t get its usual boost in consumer spending from February through May refunds (about $285 billion in 2017 and 2018), economic growth in the first half of 2019 may be lower than expected. If folks are disappointed by their reduced refunds, they will like the TCJA even less than the latest polling indicates. Democrats will campaign harder against the law. Republicans will be less effusive in their praise. Because the tax bill was intended to be a signature achievement of the prior (115th) Republican-controlled Congress and the current administration, the chances of Republican success in the 2020 elections will diminish. So an increase in the corporate rate will more likely become a reality, along with further tightening of international tax rules that many Democrats are seeking.

Not So Fast

On the other hand, there is some reason for Republicans to be hopeful that taxpayers’ disappointment with their lack of or reduced refunds won’t be significant. In fact, it may turn out that the opposite is true and most taxpayers receive larger refunds. In that case, the disaster scenario for them described above reverses. Disapproval in the polls with the TCJA may swing to approval. Republican prospects for electoral success improve. And the TCJA will be under less threat from the Democratic left.

Why do we say tax refunds might increase? There are four reasons. First, all the Treasury and GAO commentary is based on Treasury simulation model estimates that simply could be wrong or misinterpreted. For example, average refunds may be down, but if those lower refunds are concentrated among higher-income taxpayers, the number of taxpayers receiving larger refunds could increase (so, on net, the number of voters with a favorable view of their refund increases).

Second, as noted, actual data so far are only a small fraction of the total and may not be representative. As shown in Figure 1C, average refund amounts for the first two weeks of the filing season are not indicative of their levels for the entire filing season. Moreover, this year’s early refund figures could be different than in prior years because of the reduced number of refunds shown in Figure 1A. Despite IRS staff in place to process refunds during the government shutdown, it does appear the shutdown affected the number of refunds processed.

Third, we have our own (admittedly uncertain) back-of-the-envelope estimate that says so. It goes like this: Without any change in law and with an economy that has grown by 5 percent (in dollars not adjusted for inflation) from 2017 to 2018, we would expect income tax liability to grow by 5 percent. Offsetting this is TCJA tax cutting, which was estimated to reduce total tax receipts by about 6 percent in calendar year 2018 (over what they would be otherwise). The TCJA probably reduced individual income tax receipts by about 10 percent. If these ballpark guesses are correct, the reduction in tax liability from 2017 to 2018 would probably be about 5 percent. If a wage earner’s tax liability (say, $5,000 from 2017) is reduced by 5 percent (to $4,750 in 2018) and withholding has been reduced by about 3.5 percent suggested by the aggregate data in Figure 2 (say from $5,500 in 2017 to about $5,300 in 2018), that wage earner’s refund would increase from $500 ($5,500-$5,000) to $550 ($5,300-$4,750).

Finally, nobody seems to be taking into account other income tax payments, which are large and which have increased significantly, by 18 percent, from $538 billion in 2017 to $633 billion in 2018 (as shown in Figure 2), probably resulting from increases in estimated payments. This increase in tax payments before filing could also increase refunds.

Soon, but Not Yet

Bottom line: It’s too soon to tell how the refund story will end. But by the beginning of May — when refund data for 2018 are available to complete figures 1A, 1B, and 1C all the way to their right-side axes — we should have a pretty good idea of whether refunds are making the citizenry happy or sad. And that, more than anything else we can think of, will tell us in which direction the popularity — and therefore the durability — of the TCJA is headed.