What is a Tax Refund?

By | February 26, 2014

There are two reasons people get tax refunds:

  1. They overpaid their taxes throughout the year.
  2. They qualify for refundable credits that exceed their tax liability.

One is pretty straightforward. The federal government doesn’t like to wait for its money for several reasons (1, they find that people are much more likely to pay when they have to pay throughout the year automatically, rather than having to write a big check at the end of the year, 2, people tend to be irresponsible and if they are given the opportunity to pay all of it at the end of the year they tend to not have enough money, meaning the government needs to borrow more 3, the government incurs expenses continuously all year long, rather than having to borrow and pay interest it makes sense to collect taxes continuously to cover the costs), so they estimate how much you’ll owe and make you pay throughout the year. You pay that. At the end of the year, you re-assess. Maybe you made less money than you thought you would; maybe you had a baby, maybe you bought a house.


What is Tax Refund?

These are all things that change your tax liability because the government provides incentives for you to do these things. So you find out you overpaid – at that point, the government says “whoopsies” and cuts you a check for the difference. The catch is this is an interest-free loan to the government (ie a bad idea), so the goal of any taxpayer is to get the estimate as close to reality as possible. It’s theoretically better to owe a little bit at the end of the year, than it is to get a little bit back (because then the government is loaning you money interest free). You don’t want to have to pay back too much, because then guys in black suits from the IRS show up and start asking uncomfortable questions about that new car in the driveway.


What is the EITC and Tax Refund?

Two is less so; basically, the federal government ‘legislates through the tax code’ – this is when the government wants people to do something, but because it is a democracy they can’t simply send the cops over and force them to do it, so they offer a ‘bribe’ in the form of a tax credit. If people do the thing the bribe is trying to get them to do, they get a cash prize (called a tax credit) from the government.


Getting an EITC Tax Refund

Now, recall from the above graph that you want to basically pay your taxes spread out and owe nothing when ‘true up’ time comes in April. Well, you aren’t allowed to factor the ‘bribe thing’ into your taxes (ie, you can’t plan on getting a credit – you have to do the thing, then you get the credit), so if you, say, go back to college to get a degree the government offers you a tax bribe of up to $1,000. At the end of the year let’s say you owe the government $1. Because the bribe is ‘refundable’ – meaning that not only can you use it to pay your taxes, you can use it to get money back – you will get a check for $999 from the government. It’s kind of a backwards bribe order (usually you bribe someone, then they do the thing they said they were going to do) but ultimately it works the same way.