Table of Contents

In many of America's poorer neighborhoods, storefront tax services are a common seasonal sight. Touting fast cash and hassle-free filing, these outlets lure millions of working-poor customers each spring.

But what they don't advertise is the price of their promises, which is steep.

In Washington, D.C., for example, the average storefront charges about $100 to prepare a return and file it electronically. Preparers also command exorbitant fees for "rapid refunds," which are actually short-term loans with very high interest rates -- much like payday loans. These "refund anticipation loans" (RALs) cost from $40 to $300 in the Washington area, or even more, depending on the bank and the size of the refund.

Last year, for example, an H&R Block rapid refund cost a customer in Washington $121 in fees on a refund of $2,500 -- a high price for an "early" refund that saves only about a week's wait. The annualized interest rate on this RAL, in fact, is about 250 percent.

The high cost of these services hurts not only individual families but diminishes the impact of the government's largest anti-poverty program, the federal earned income tax credit (EITC). Every year, the EITC provides refundable tax credits to low-income parents who earn less than about $32,000 for a family of four. In tax year 2001, a minimum-wage worker with two children could receive a credit of $4,008. The program's reach is enormous: In 2000, more than 19 million working families claimed $32 billion in EITC refunds.

But by the time all of 2001's EITC refunds are paid, tax preparers will have siphoned away a conservatively estimated $1.75 billion - money Congress intended for the poor, not the tax preparers. This is because at least 60 percent of families who earn the EITC pay someone to file their taxes. Moreover, almost half of these families also buy a RAL. Relying on low-wage workers to fuel their business, tax preparers divert huge sums annually from working-poor families, especially those who receive the EITC.

Low-income workers rely on high-cost tax services for several reasons. First of all, tax service storefronts can offer their customers fast cash -- an undeniable attraction for the poor. Because they often receive large refunds, many low-income families are anxious to claim their refund dollars quickly. Tax services not only offer electronic filing (which can speed up the Internal Revenue Service's processing), but RALs can, in some instances, also permit customers to walk out the same day with a check. Moreover, because all fees are automatically deducted from the refund, nothing is owed upfront.

Second, the tax code is quite complex -- especially the EITC. For example, the IRS instruction booklet explaining the credit is a staggering 56 pages long, and includes six separate worksheets. An additional complication this year is the new refundable child tax credit, which was one of the few bright spots in the 2001 tax cut. Although the child tax credit should prove to be an important supplement to the EITC for working poor families, it has its own set of rules and is not easy to claim (see sidebar, right).

Third, tax service storefronts are ubiquitous in lower-income communities. Our research shows that in the nation's 100 largest metropolitan areas, outlets registered with the IRS are 50 percent more likely to locate in zip codes with a high proportion of taxpayers who claim the EITC. In San Antonio, for instance, an average of 20 tax preparation services operate in each of the nine zip codes in which at least a third of all families receive the EITC.

Of course, no one forces poor taxpayers to walk into the tax preparation storefronts. Unquestionably, professional services fill a necessary function and without them many poor families might get no EITC at all. Yet clearly the public interest is not served when a tax credit designed specifically to supplement the earnings of low-income working families with children subsidizes a growing, multi-billion dollar industry.

How can we remedy this unintended exploitation of low-wage workers? For starters, policies that have directly aided and abetted the industry in recent years must be changed. For example, the IRS is prohibited from competing with the tax preparation industry, thus limiting the agency's ability to provide free software and online filing.

Lifting this prohibition, at least as it applies to low-income taxpayers, can ease the financial burden that paying for tax preparation imposes on many families. In addition, there are a number of other steps that could provide working families with better access to their full tax refunds:

1. Simplify the EITC and the refundable child tax credit. Although complexity in the tax code is inevitable, the rules governing these credits are needlessly complicated. And even though last year's tax bill included a few good changes, such as the simplification of some EITC definitions, there's ample room for more reform. One solution, proposed by Isabel Sawhill of the Brookings Institution, is to combine the EITC and the child tax credit into a single, streamlined benefit that families can easily claim, without professional help.

2. Provide low-income taxpayers with more free tax help and free electronic filing. The Volunteer Income Tax Assistance program, sponsored by the IRS for lower-income taxpayers, completed only 101,000 EITC returns for the 1997 tax year. Given more funding, though, locally operated Volunteer Income Tax Assistance programs could reach many more low-income taxpayers who might otherwise resort to paid preparers. A $10 million grant program, administered by the IRS and matched with state and local dollars, could support the filing of nearly 1 million returns for low-income taxpayers annually.

In addition, Congress and the administration should permit the IRS to offer online filing and free tax preparation software in low-income neighborhoods, at venues such as public libraries and Volunteer Income Tax Assistance sites. Besides saving taxpayers money on preparation fees, free electronic filing should also lessen the demand for rapid refunds, which are an outgrowth of the near-monopoly on electronic filing that paid preparers now enjoy in low-income communities. At the very least, the IRS should make a concerted effort to inform low-income taxpayers of any available opportunities for free or low-cost tax assistance, such as the free online tax service currently provided by Intuit, the financial software company, for anyone who earns less than $25,000 a year.

3. Promote financial literacy. Many filers may not know the real cost of a rapid refund. Raising consumer awareness -- through public service announcements, community efforts, or even a simple brochure included with tax forms -- can help prevent costly mistakes.

Over the past decade, the EITC has helped move millions of families into the workforce and out of poverty. But it has also helped to create a burgeoning marketplace for tax preparation services -- one that profits these businesses at the expense of the poor. Sensible changes in tax and government policies will help ensure that families receive the full benefit of the EITC to which they are entitled.

Further Reading:

"The Price of Paying Taxes: How Tax Preparation and Refund Loan Fees Erode the Benefits of the EITC," by Alan Berube, Anne Kim, Benjamin Forman, and Megan Burns; The Brookings Institution and The Progressive Policy Institute; May 21, 2002.

Anne Kim is director of the Work, Family and Community Project at the Progressive Policy Institute. Alan Berube is Senior Research Analyst at the Brookings Institution Center on Urban and Metropolitan Policy. Research assistance was provided by Megan Burns and Benjamin Forman.