We will begin by summarizing a previous response[1] that explains why it is permitted to buy Israeli bonds and thus take interest from the Jewish State, as the topics overlap. We will then focus on some differences between the two cases.
Several poskim[2] permit taking interest from Jewish-owned corporations because ribbit is forbidden only when a borrower has personal liability. Even some who disagree with that halachic thesis[3] permit lending to the Israeli government (i.e., buying its bonds), because a government has no clearly defined owners, but is rather an amorphous representation of an ever-changing population.[4] The Israeli Treasury also has a general heter iska.[5]
Although one might think that it makes no difference what the basis for permissibility is, if the heter iska is indeed required, matters are not as simple as they would be were there no problem of ribbit at all. While many view a heter iska as some sort of “magic formula” that erases the prohibition of ribbit, it actually is a real financial document that changes the rules governing how the money that is due is to be returned. (Based on the heter iska, not always will all the expected “interest” be paid, and it is even possible that not all the principal will have to be returned.) Since a heter iska is an agreement to a nonstandard investment arrangement, both sides to the transaction must agree to its terms for it to be valid. When one decides to buy government bonds, he agrees to the rules that govern them, including the heter iska that apply to the bonds (even if he never bothered to “read the fine print”). Similarly, when one deals with a bank, he accepts the terms of their general heter iska, the agreement between the bank and its customers, which includes principles of iska. But when does a person whose income is withheld for income taxes accept the terms of a heter iska agreement? (It is difficult to claim that it is when he decides to live and/or work in Israel. However, it is possible that since practically the heter iska is for his good, it can be assumed that he is agreeable, even though in theory it could cause him to lose money.)
In addition to the grounds for leniency that we have seen above, there are other reasons for leniency that apply to tax refunds that do not apply to government bonds. One of the basic rules of ribbit is that the Torah forbids a borrower from paying interest specifically to the one who lent him the money.[6] When a worker has taxes withheld, which is the normal manner in which most of one’s income tax is paid by law, the worker does not actually give money to the tax authorities. Rather, the government requires the employers to give them the money (which entitles the employers to pay the worker less than his gross salary). In fact, if the employer fails to withhold the money properly, he is legally accountable. Thus, when the Treasury pays the excess to the employee with interest, it is not paying money to a lender, but equitably completing the payment process of income tax collection in a manner that differs from returning loans. This idea will not work for prepayment of taxes by self-employed individuals, however, as they themselves do the paying.
The most significant leniency that applies in this case results from the distinction we made above: The taxpayer does not choose to pay the tax authorities, nor does he agree to the timing of the payment and the refund. All decisions are made unilaterally by the government, and they are permitted, barring an unusually corrupt system of levying taxes, to make up rules under which they increase or reduce taxes. Several poskim[7] use this logic to allow the government to take “interest” from a taxpayer who is late in paying taxes (i.e. owes money). Since the government can take additional money as it sees fit, we do not consider their decision to impose a late fee as equivalent to interest on a loan, but as part of the unilateral rules of taxation. Similarly, the government is permitted to give discounts for early payment of taxes,[8] which is common regarding municipal tax. The same logic applies to the government’s decision to return more money than is actually due to those from whom too much was withheld, without it being considered forbidden ribbit.
By means of any combination of the arguments above, it is certainly permitted to accept an income tax refund with interest.