How Income Volatility Complicates Taxes and Planning

Significant changes in income from month to month, also known as income volatility, may complicate tax filing and planning for critical tax benefits, according to new research published by the Urban-Brookings Tax Policy Center, “Income Volatility: New Research Results with Implications for Income Tax Filing and Liabilities.”

Elaine Maag, an expert on tax policy and one of the authors of the report, describes the situation. “The classic idea that lawmakers may have in mind is that someone has a full-time, full-year job, and they get one earnings statement at the end of the year from that employer, and they take that to their tax return preparer and all is good. But that’s just not the reality anymore.”

Contrary to the classic notion of the taxpayer situation, Maag’s research finds that increasing volatility in monthly income contributes to large numbers of Americans feeling financially insecure. Half of working-age adults have household income that spikes or dips by 25 percent or more than their average household income, at least one month of the year. Moreover, nearly 40 percent of low-income, working-age adults have household income that spikes or dips at least six months of the year.

Factors that Drive Household Income Volatility

According to the research, the evolving nature of work and changing trends in family dynamics are related to unpredictability of household income. Households that depend on self-employment income, for example, often have several income sources and inconsistent income sources. Likewise, changes in who contributes to the household income are increasing as family dynamics trend away from the traditional family structure. Households that have several income sources, inconsistent income sources or changes in who contributes to the household income experience, spikes or dips more frequently than adults in other households. Furthermore, each of these factors also complicate tax filing.

 Implications for Taxes and Planning

Income swings can make it difficult to compile the information needed to file tax returns and to predict and plan for tax obligations. This may be especially true for low- and moderate-income families eligible for refundable credits such as the earned income tax credit (EITC) and child tax credit (CTC). Below is a case study from the report that illustrates a potential implication for a low-income family with two children:

Suppose a family with two children began 2016 with monthly earnings of $1,161 and expected those earnings to continue throughout the year. The family’s earnings would have been $13,932 in 2016, which would qualify the family for an EITC of $5,572 and a CTC of $1,640. Because this family would have no income tax liability, they would receive an income tax refund of at least $7,212 ($5,572 + $1,640, plus any tax that had been withheld through the year). If, however, the family’s earnings dropped 25 percent during the final four months of 2016, their earnings for the year would be $12,772, a decline of $1,161 from the $13,932 they expected to earn at the beginning of the year. But, their EITC would also decline by $464 (from $5,572 to $5,108), and their CTC would decline by $175 (from $1,640 to $1,465), reducing their refund by $638. The total reduction in the family’s financial resources would therefore be almost $1,800, 55 percent larger than the $1,161 reduction in earnings alone.

Although the family still qualifies for the EITC in this example, many families will move from being eligible for some credit to being ineligible. Although millions of families receive an EITC every year, the population is not stable. Over a 10-year period, analysts found that 61 percent of EITC recipients claimed the credit for two years or less (Dowd and Horowitz 2011).

Additional Resources

• View a short video of Elaine Maag of the Urban-Brookings Tax Policy Center discussing income volatility and taxes.
• View the research report: Income Volatility: New Research Results with Implications for Income Tax Filing and Liabilities
• View a recap of the panel discussion with leading researchers, practitioners and policy experts on how households experience income volatility and ways current policies help or hinder families predict and plan for tax obligations and windfalls.