The Non-Threat of Smaller Tax Refunds

There is nothing certain in life but death and taxes … and financial headlines dwelling on taxes in late March. As America continues scrambling, procrastinating and filing, the IRS churns out regular updates on the amount and contents of return processed. One item attracting particular attention this year: the fall in the average refund. Several outlets have highlighted this, warning it will detract from consumers’ spending power this year. We think they are overlooking some mitigating factors, both from a personal finance and consumer spending standpoint.

Most coverage pegs a simple reason for refunds being down: the expiration of temporary COVID-era tax deductions and credits. This includes the expanded child tax credit, the more generous charitable deduction and the “stimulus” payments, some of which came with 2021 tax refunds. These explanations seem consistent with the average refund slipping from $3,305 to $2,933 thus far in the filing season.^[i]

Yet in our view, equating this with deteriorating household finances across the board seems like a stretch. Yes, those who benefited from the refundable credits and higher deductions are taking a small hit. But that is not the only change this year. Tax band thresholds are up, as they are indexed to inflation. Exhibit 1 shows the change from 2022 to 2023.

Exhibit 1: Tax Bands Are Inflated, Too

Source: IRS, as of 3/23/2023.

This isn’t a huge windfall, of course. Rather, it is a small salve for those whose pay didn’t rise with consumer prices. By our math, an individual earner making $100,000 annually and taking the standard deduction would pay just shy of $350 less than last year. Taking advantage of higher retirement account contribution limits and other benefits would further reduce the burden. Different households’ experiences will vary, but overall, while people might be getting smaller refunds, they are probably having less withheld from their paychecks. For many households it could very well be a wash or close to it, limiting the potential spending impact.

Then too, equating tax refunds with consumer spending power isn’t quite right. For one, consumer spending is mostly on services and tends not to sway wildly. Furthermore, not everyone spends their refund. Some save them. Some invest them. Some pay down debt with them. Heck, even viewing a refund as an outright positive doesn’t hold up, in our view. Getting a big refund means you made a sizable interest-free loan to the IRS. When the shoe is on the foot and you underpay throughout the year, the IRS assesses penalties to make up for it—but rudely, they don’t tack interest onto your refund. There is no compensation for the fact that you could have done something better with your money during the past several months. So we reckon the correct response to a big refund is to grumble and check your withholdings, not to celebrate.

But that is a philosophical issue, not a market-related one. For stocks, the simple question is whether economic growth turns out better or worse than expected. The tax changes affecting this year’s refunds are quite widely known. People have bemoaned the expiring breaks for months. Even before 2022 ended, we saw headlines bemoaning smaller refunds’ effects on spending. Given they were temporary when passed, we rather doubt markets penciled in an indefinite boon for American families. More likely, they did what they generally do with temporary tax changes: sighed, priced in the eventual sunset and moved on.