Philadelphia Reflections

Tax Credit Time

Here's how a discouraging proportion of indigent tax credits go right into the pockets of predators.

Dr. Fisher

If we would only listen, most people have a fascinating story to tell. They usually talk quite freely. Take an illustration from the casual observations of an employee of a tax-preparation service. For him, late February to mid-March is "Tax credit time".

Normal behavior for tax-payers is to wait until the last possible moment before the April 15 deadline, not even thinking about unwelcome income taxes. Commercial tax-preparation services have few if any tax-paying customers in March, but are nevertheless extremely busy. The chairs of their waiting area are occupied by citizens, anxious for the government to pay taxes to them as early in the year as possible.

This startling role-reversal is a result of the tax credit system, which should not be confused with tax deductions. In the case of a tax credit, the government issues a check to make up the difference between what the individual earned during a year, and a certain stated income level. No doubt such benevolence is hedged with innumerable rules, restrictions, limitations, and exceptions, which tax preparation services must know all about and, in effect, certify by countersigning the completed tax form. Following that moment, there is a delay of up to three months before the green government check actually arrives. Since a loan against such pending payments is essentially risk-free, the tax preparation service is more than happy to lend it to the recipient. A fairly representative example would be to charge $200 for the preparation service, plus an additional $200 for the three-month loan of, typically, $7000 in tax credits. Where does that lump-sum payment usually go? Almost invariably, it goes to pay down the unpaid balances of credit cards, otherwise running up 18-30% interest, 23% typical. Since David Swensen of Yale's endowment fund is claimed as the world's best investor for achieving a 17% return, the welfare recipients who effectively get 23% by paying off credit cards -- are making a very good investment decision. Indeed, they aren't being swindled out of anything; they come into the tax preparation services loudly demanding just exactly this product. Although they are mainly unwed mothers in their 20s and 30s, they have obviously been well instructed by their friends about how to make quite a shrewd and entirely legal arrangement.

It's only when you ponder the further implications of this whole process that you begin to wonder if there isn't a more efficient way to handle it. Since the underlying security is the full faith and credit of the United States Government, the loan is essentially risk-free. At a time when commercial mortgages are charging about 6%, these loans imply an extra risk premium of at least 15%. If you regard the welfare client as merely a passive intermediary, a $7000 tax credit payment costs the government $1800 of it to deliver only $5200 to the client, net. That is, about a quarter of the cost of the program is going to loan sharks. Surely, a less costly method could be devised to transmit 12 monthly checks to the clients, or even 52 weekly ones.

Beyond that, there is the uncomfortable question of just where we are going with tax credits. Without begrudging a nickel to the poor unfortunates who are helped by this program, it is alarming to hear that low-income housing and historic rehabilitation of old structures are both rewarded with 20% tax credits, and the idea is spreading that it might be a good idea to pay for health insurance with tax credits. We've opened a door here that we may wish we hadn't opened. Echoing the views of Alexis de Tocqueville, Alexander Fraser Tyler has summed it up: "A democracy...can only exist until the voters discover that they can vote themselves money from the Public Treasury."

Originally published: Tuesday, March 06, 2007; most-recently modified: Thursday, June 06, 2019