John Pitts is the Policy Lead for Plaid. Before joining the company he was the Deputy Assistant Director for Intergovernmental Affairs at the Consumer Financial Protection Bureau.

Every year, the majority of Americans receive a significant windfall in the form of a tax refund.

The impact, both for individuals and the economy, cannot be overstated. Tax refunds are the single biggest tool by which Americans generate lump-sum savings, representing 2.5% of U.S. gross domestic product, according to an analysis of one million accounts by JPMorgan Chase & Co. Institute.

Average refunds, which hovered around $3,600 last tax season, equated to nearly six weeks of take-home pay for the average family receiving them. (article continues below)

courtesy of John Pitts

While many people absorb their refund into their regular income or save it, refunds go hand in hand with significant events in the economic lives of American families. These include increases to credit card payments, spending on durable goods, and healthcare payments. It’s no coincidence that out-of-pocket spending on healthcare services increases 60% the week individuals receive a tax refund—and remains elevated for 75 days.

But this pillar of taxpayer’s annual balance sheet may be cracking. The IRS revamped withholding forms for 2019 with the goal of giving people more accurate withholdings. The explicit goal here is zero refund. Early 2019 tax refunds were lower than many taxpayers expected, and they were not happy with the surprise.

Out-of-pocket spending on healthcare services increases 60% the week individuals receive a tax refund—and remains elevated for 75 days.

While the most recent figures put average refunds back where they were last year, next tax season could be a different story as policymakers continue their push for accuracy.

Most Americans don’t want this change, nor can they afford it without significant changes to their budgets. But tax refunds have always been an imperfect form of “savings.” The question, for employers and policy makers, is how to turn this disruption into an opportunity to provide individuals with better options to build rainy-day funds, and in turn improve their overall financial outlook.

How refunds became the de facto savings plan.

Financial advisors have long preached that a tax refund is nothing to celebrate.

After all, a $3,000 refund really just means the taxpayer made a $3,000 interest-free loan to the government. It’s not a great deal for the taxpayer, especially when the government would gladly pay 2.55% interest on the same money put into a T-Bill for 12 months.

But most Americans say they would rather have a refund than get a bigger paycheck, according to a poll by Bankrate. Among those earning less than $30,000, 63% of people indicated they’d prefer the lump sum, while 53% of people earning more than $75,000 said the same. (article continues blow)

Like it or not, a significant portion of the population relies on this money as a de facto emergency savings plan, according the JPMorgan Chase study. Even a bad savings vehicle is better than nothing in an economy where most people lack necessary rainy-day funds. Four in 10 American households would not be able to come up with $400 in the event of a financial emergency, according to the Federal Reserve Board.

With tax refunds shrinking, Americans need to look to other methods for bolstering their near-term savings.

Do spare change apps add up to an answer?

Fintechs have made inroads to improving savings habits via so-called spare change apps. While each has a slightly different approach, the idea is not unlike over-withholding on taxes.

Launched in 2014, Acorns rounds up credit- and debit-card charges to the nearest dollar and invests that money in exchange-traded funds; users have additional options for increasing their regular savings or making one-time contributions.

The question, for employers and policy makers, is how to turn this disruption into an opportunity to provide individuals with better options to build rainy-day funds, and in turn improve their overall financial outlook.

Digit uses algorithms to analyze your bank account activity so it can make daily small withdrawals that you won’t notice. Whereas Acorns and similar apps focus on investing, Digit sends the funds to an FDIC-insured savings account. Users can elect to save toward different goals, from building rainy-day funds or saving for a vacation to paying down credit card debt.

The idea is gaining traction. U.S. consumers have opened more than 7 million such accounts and saved nearly $5.6 billion in 2018, according to Cornerstone Advisors. Yet many of these apps are geared toward long-term investing—as opposed to all-too-crucial cash—and adoption is still low, with roughly 4% of Millennials and Gen Xers using savings apps, and less than 1% of Baby Boomers.

What’s more, the individuals who could use the most help saving may need a nudge to get started. That’s where employers and policy come in.

Employers can do more.

In 1978, a small addition to Section 401 of the Internal Revenue Code created the now-ubiquitous 401(k) plan. It is the primary vehicle by which Americans save, with 55 million active participants and more than $5.6 trillion in collective account balances.

In fact, 401(k)s were slow to take off, with only 47% of eligible workers signing up during the early years. One reason for low adoption: the default was for workers to contribute $0 to their plan, so anyone who wanted the benefit had to “opt-in.” (article continues below)

In 2006, Congress reversed this presumption and paved the way for employers to auto-enroll their employees. Individuals could still “opt-out” of the 401(k), but if they did nothing, they would make contributions. This feature has since swelled in popularity, with 60% of plans now automatically enrolling would-be participants in retirement plans. Among new hires tracked by Vanguard, participation rates nearly double to 93% under automatic enrollment.

What if employers made a similar push to help employees bolster their cash cushion? In a recent survey by the AARP Public Policy Institute, three out of four adults surveyed said they were interested in a payroll deduction program aimed at helping them accrue liquid savings.

To that end, Prudential Financial recently launched a new option for emergency savings that can be added alongside its retirement plans. The savings is an after-tax contribution that allows employees to automatically put money away in low-cost investments such as money market accounts or stable value funds.

While it’s still early days for employer-sponsored rainy-day funds, human resources groups and researchers have started giving a serious look to such benefits.

Encouraging savings at a policy level.

Help from employers is one thing, but a partnership between employers and the government may be necessary to truly replace the refund with a better option.

One idea: Congress could require the IRS to revise the W-4 to let taxpayers pick their own “refund.”

As it stands, there are no federal or state program or incentives aimed at encouraging Americans to bolster their rainy-day savings. Policymakers will have a much easier time eliminating the tax refunds people like if they offer a better alternative.

One idea: Congress could require the IRS to revise the W-4 to let taxpayers pick their own “refund.” Instead of withholding too much, the program carves out money from each paycheck to put into into Treasury Inflation-Protected Securities (TIPs) to ensure that the taxpayer gets that windfall on April 15.

Ideally this plan would borrow from the lessons learned with 401(k)s and default most taxpayers into a minimum “refund.” Introducing such an option—from which taxpayers could always opt out—would replace the much-criticized interest-free loan with an interest-bearing loan. It would also maintain the "tax refund" component of annual family budgeting.

Introducing an option for Treasury Inflation-Protected Securities would replace the much-criticized interest-free loan with an interest-bearing loan. It would also maintain the "tax refund" component of annual family budgeting.

Why stop there? Millions of consumers now use fintech apps to manage their budgets. Policy makers could require the IRS to open its tax filing software APIs to create the space for employers and third-party financial services companies to build products that connect this kind of savings to the actual tax withholding and preparation process.

Such a model has the advantage of tapping directly into the savings into the tools taxpayers have chosen to manage their money through the year.

From windfall to dependable savings tool.

There is no reason that consumers who use modern financial technology to track every dollar they earn and spend should be surprised by the size of of their most important annual check. Incorporating tax data directly from IRS and employers turns the refund from an uncertain annual bonus into a predictable short-term savings strategy around which consumers can plan their financial lives.

Whatever the solution, it’s time for policy makers to look seriously not just at replacing the tax refund, but at supporting innovative solutions to help Americans build the cash cushions they need—and want.

John Pitts is the Policy Lead for Plaid. Before joining the company he was the Deputy Assistant Director for Intergovernmental Affairs at the Consumer Financial Protection Bureau.