A recent paper from the National Bureau of Economic Research has found that tax refunds create a spike in bankruptcy filings by as much as 7 percent.
The reasoning behind this spike is due to households needing to file bankruptcy but not having the cash on hand to actually declare bankruptcy. The tax refunds actually help to fund that process.
Nearly four percent of bankruptcy filers would have been able to file bankruptcy if the tax refunds had not been available.
The authors correctly note that in the absence of any governmental safety net for consumers facing financial trouble that bankruptcy acts as a social insurance program to help rescue consumers from situations they would otherwise not be able to escape and rebuild from.
While bankruptcy can often provide consumers with a quicker way to deal with difficult financial problems, there is a barrier of mandatory filing fees and in the case of most chapter 7 bankruptcy cases, paying the attorney in advance of filing. Tax refunds and rebates provide a sudden influx of cash that can be used to address and dispose of the financial situation promptly.
In contrast, chapter 13 bankruptcies where bankruptcy attorneys are generally paid over the course of the bankruptcy, showed less influence with the injection of tax rebates and refunds. This seems logical considering that other than the mandatory bankruptcy filing fee, most chapter 13 bankruptcies already provide for an installment plan when paying bankruptcy attorney fees.
The paper notes:
We find that tax rebates cause a significant, short-run increase in consumer bankruptcies. This evidence is consistent with the hypothesis that legal fees force liquidity-constrained households to delay filing. These results highlight the importance of liquidity constraints in the optimal design of the consumer bankruptcy system.
A recent USA Today article by Christine Dugas quoted one of the papers authors on the subject of 2005 bankruptcy reform simply making filing bankruptcy more expensive.
The law was changed to prevent bankruptcy abuse. It was thought that too many people who could afford to pay their debts were taking advantage of the system.
“But if you want to curtail abuse, raising the cost is not a good way to do it,” says Jialan Wang, assistant professor of finance at Washington University in St. Louis and an author of the NBER study. “The people who really need bankruptcy are the ones who will be unable to pay for the fees.” – Source
According to Kim Coleman, a bankruptcy attorney in Philadelphia, “I definitely think that tax refunds are used to provide consumers with cash to file bankruptcy when they otherwise cannot. In fact, many of our clients use tax withholding which typically becomes a refund as a sort of savings account that they withdraw during tax season. They might use this as a vacation fund in better financial times, but in these rough times some use it to file a bankruptcy case or get caught up on their mortgage. We even mention in our direct mail marketing that they can use their refund to pay for filing a bankruptcy to get out of debt.”
She also mentioned some key advice I’ve given in the past as well, if you are getting big tax refunds you are probably having too much taken out of your paycheck when you need it most, each month.
Coleman said, “Sometimes though I advise clients to change their withholding to help them meet their bills as they come due during the year. Or, if they are getting a large refund and planning to file bankruptcy, we have to try to protect the refund from becoming an bankruptcy asset that can be distributed to their creditors by “exempting” the refund in their bankruptcy case.”
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