RALs

A refund anticipation loan is an advance made to a tax filer against the expected refund that he or she will shortly receive from the IRS.  RALs are relatively unknown to most people.  For the poor, though, it is a different story.  RAL providers are there if you look for them – at the Jackson Hewitt, the H&R Block, or at the independent tax prep chain down the street.

In most instances, the RAL consumer is also a recipient of the Earned Income Tax Credit.  This is a good program, developed in the 1970s by Richard Nixon and characterized as incredibly successful by Ronald Reagan, that relieves poverty.  It is refundable, so workers are rewarded for earning more money.

The IRS participates in the underwriting of RALs.  Tax preparers can ask the IRS if a RAL applicant has any outstanding tax liens.  These might consist of back taxes, defaulted federal student loans, or missed child support payments.  These filers might meet the standards for the EITC, but with those liens, they will not get a refund.  The IRS’ program, referred to as the debt indicator (pdf), warns preparers ahead of time.

So, its a case of one hand taking from the other. On one hand, the federal government’s main anti-poverty program is working to improve the living standards of the working poor.  At the same time, the IRS is spending its time and resources to facilitate a private loan industry that intercepts those payments.

The debt indicator removes the only risk, aside from fraud, for preparers.  That lack of risk makes it hard to understand the pricing of RALs. The price of a RAL, in terms of an APR, can be over 200 percent.  You can get $1500 tomorrow (you have to wait one day to get your refund with a RAL), rather than waiting to get $1700 in about ten days.

Often, people pass off the seeming lack of logic concerning the use of refund anticipation loans as evidence that the poor make poor decisions, or that they fail to understand the time value of money. When described by academics, there’s even a name for people who exhibit this kind of decision-making: they are individuals with a “high discount rate.”  What this means is that the poor, in this example, value money in the present greatly.  They would take a dollar today over a much higher amount in the future.

I think the mechanics of a RAL tell us that this academic description of how the poor are making decisions is a little bit off the mark. Borrowers who get RALs avoid paying for their tax preparation services out of pocket. It might cost them $150 otherwise to get taxes done at one of the mainstream franchise tax prep services. That can be a lot of money to a person trying to support a household on a minimum wage salary.

I’ve created one such scenario in this post.

It would be wrong to conclude that RALs only inform us about the credit decisions of the poor.  In fact, their prevalance also suggests something about the availability of credit to low-income households.   The low-income characterization is an important thing to remember.  Refunds generally go only to people who work.  These are people with jobs, but without adequate credit.  It suggests that there is little recourse to find credit elsewhere for these poor consumers.  The only loan product that could be more expensive might be a payday loan.  Even credit cards would be far better – suggesting that for many of these consumers, credit cards are out of reach.

RALs are down.  There were 8.5 million RALs during the 2008 tax year.  That is a drop of fifteen percent.  Much of that business has been replaced by refund anticipation checks.  11.5 million consumers used a RAC in 2009.  RACs are a better solution.  They satisfy the cash flow constraints of a low-income filer, but they generally cost about $30.

Ultimately, RALs may go away not with a legal change, but through the improvement of IRS technology.  In some instances, filers can now get their refunds direct deposited in one day, although the normal wait time can be as long as ten days.  The uniformity of these returns suggests that better programming could ultimately speed up response times to the point where RALs no longer present a value proposition to working households.

Current Issues

Since 2009, the RAL market has been in a state of great change. In December 2009, the OCC forced Pacific Capital to cease its RAL business. HSBC, RAL provider to H&R Block, is expected to shut down their activities in two years. Mark Ernst of the IRS has doubts about the value of the debt indicator. A new entrant, MetaBank, may gain approval to provide RALs. If they did, it appears that they would originated RALs through a relationship with Jackson Hewitt. JTX is itself in some trouble. Its shares have declined dramatically in the last year, and save for a new agreement on a $100 million line of credit from Wells Fargo, the future is bleak. The IRS has put new standards for tax preparers in place. Going forward, a new bill (HB 10-1400) would require registration and standards for electronic return originators that want to provide refund anticipation loans.

Consumers continue to drift away from RALs and into refund anticipation checks. It seems possible that RACs may help to answer the need for settlement of tax prep costs.