Use tax refunds to help Americans save

President Bush has put tax and social security reform high on the agenda for his second term. He's highlighted the need to increase retirement savings and called the tax code a complicated mess that hinders the economy. Another fundamental drag on long-term growth is our low personal savings rate, and the tax code doesn't help here either. But there's a simple reform to the tax system that can help millions of Americans increase their savings without changing any laws or spending a dime.

Every year, the IRS sends out refund checks averaging $2,100 to more than 120 million taxpayers. These tax windfalls often provide families their best opportunity to save. Right now, taxpayers have one choice: the entire refund comes back in a lump sum. If we make it easier for people to save right on their tax forms, to split their refunds into "money to save" and "money to spend," people will save more - perhaps much more.

Could such a small change make a big difference? Yes. If we've learned anything about saving over the past several years, it's that income alone isn't enough; the process of saving must be made easy. When a tax filer learns that she's getting a $2,000 refund, she should be able to use her income tax form to direct $500 of it to her IRA, send $500 of it to pay down her Visa bill; and use the rest to fix her car. She should be able to make these choices before her refund money is in hand and spending temptations are too hard to resist.

Using tax returns to encourage people to save and build assets is nothing new. Over the past few decades Congress has incorporated well over $300 billion a year in tax breaks to promote saving for retirement, college, homeownership, and investment - and one wonders how much wealth creation would have occurred if it weren't so well structured. Nor is it news that employers have long set up 401(k) retirement accounts for their employees and then made it easy for them to save through automatic payroll deductions.

What is new is the results of a recent pilot project led by the Doorways to Dreams Fund and Community Action Project of Tulsa County in Oklahoma. The experiment proved that even low-income tax filers - those least expected to save, but who have the most need to do so - would use this "splitting" option to save more. Nearly 500 tax filers with average annual incomes of $13,440 were offered the opportunity to split their refunds - some could be put in a savings account and the rest would come back in a refund check for their immediate needs. Of the people who were offered the opportunity, about one-third wanted to participate. According to researchers at the Harvard Business School and the University of Kansas, people deposited $583 on average - 47 percent of their refunds - into savings accounts; 75 percent of these individuals had no prior savings.

Currently 20 million Americans receive tax refunds through the Earned Income Tax Credit (EITC), a work incentive available to low-income workers. The average EITC refund is around $1,700; some are as high as $4,000. Assuming a similar take-up rate to the one in Tulsa, this simple change in tax filing could generate up to $4 billion in new savings among EITC filers nationwide - again, at no cost to taxpayers.

There's also something in this for the private sector. Splitting refunds could help financial institutions penetrate an unrealized market of individuals at all income levels who can and want to save and invest more for their futures. As competition increases, savings products would become cheaper and better. Both H&R Block, which successfully markets low-cost IRAs and bank accounts to its lower-income customers, and Vanguard, which has its own in-house split-refund tool, have already figured this out. Eventually, the IRS could make it easy to open new savings accounts directly on tax returns with a check of a box.

While there are some technical issues to overcome, the IRS could make this change right now - no new legislation is required. In fact, and to its credit, the Bush administration proposed in this year's budget amending the tax-filing process to allow split refunds. However, a lot of things get listed in budgets or started within agencies that never happen. To ensure that it does, Congress should set a deadline for the IRS to make this option available for the 2005 tax season.

The budget deficit compels us to get creative about low-cost approaches to pressing national issues, including our abysmal savings rate. High-cost solutions may still be necessary to devise reforms in the areas of retirement security, healthcare, education, and economic opportunity. But if we can generate billions in new personal savings for taxpayers at all income levels at no cost to the federal government, let's do it now.

• Anne Stuhldreher is a senior research fellow and Reid Cramer is a research director at the New America Foundation.