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Imagine that you borrow $1,000 from your bank to finance a purchase. You pay this money back over the next few months. At the end of the year, the bank informs you that you paid $200 too much. It returns your overpayment but doesn’t give you any interest. How will you feel?
If you’re like most people, you’d feel a bit foolish and frustrated for not putting that $200 to better use. You could have paid down some of your other debt, put it in a savings account and earned some interest, or invested it in a mutual fund. You could have done something useful with it instead of letting your bank use it.
Yet, when it comes to income tax, this is exactly what most Americans do. So far in 2019, for example, 81.8 percent of taxpayers filing taxes have overpaid, receiving an average refund of $3,008. The U.S. government is getting a hefty interest-free loan from a majority of its taxpaying citizens—$160 billion as of early-March and counting.
Yet, amazingly, people get upset when they receive a smaller refund than in previous years. Shouldn’t they be congratulating themselves instead, for being more financially prudent and giving a smaller interest-free loan to the government or none at all? In this blog post, we’ll consider four psychological explanations for why people over-withhold income taxes and like to get a big tax refund year after year.
1) Tax refunds are visible, withholding is invisible.
Most of us pay taxes in increments throughout the year as money is withheld from each paycheck by our employers. This ingenious process was instituted during the Second World War to pay for America’s war effort but has since remained in place. Withholding tax is relatively painless and invisible. The money never reaches the taxpayer's hands. This logic of minimizing the pain of payment and encouraging invisibility has been used by behavioral economists more recently to design automatic retirement savings plans.
On the other hand, tax refunds are highly visible. They not only provide a financial windfall but also deliver a welcome emotional boost to help offset the opportunity cost of not getting the money back earlier.
2) The amount of tax withholding is dictated by inertia.
Another important feature of automatic tax withholding is that the tax-payer is required to decide how much money to withhold just once, each time they start a new job. The process is onerous. The individual has to fill out a W-4 form stating the appropriate amount to withhold.
Once set, economists have found that people are resistant to change their withholding amounts. One study found that after the birth of a child, people only reduced their withholding by only about one-third of what they should have after one year, and by about 60 percent even after three years. Similarly, when withholding is reduced due to a tax cut, people tend to spend less of their bigger paycheck right away than when they get the same amount as a one-time payment. People are relatively inert in making financial moves.
3) Paying a lump sum when filing taxes is undesirable.
Instead of over-withholding taxes from every paycheck, an individual can under-withhold all year and pay a lump sum amount covering the gap when filing the tax return annually. However, because of the underlying “pay-as-you-go principle” of income tax in the United States, if a person under-withholds a significant amount in consecutive years, they have to pay a penalty. Combine this with the facts that many people don’t know exactly how much they’ll earn by the end of the year and they are averse to owing money to the government, economists have argued that it makes sense to overpay taxes and receive a refund. What’s more, writing out a check for a lump sum amount can be psychologically painful and aversive. These phenomena all favor paying more than is necessary throughout the year and getting a refund instead of underpaying and covering the difference at the end.
4) Overpaying taxes is a form of forced saving.
Last but not least, a significant number of people use over-withholding as a form of forced saving behavior. As I’ve written before, a significant number of Americans have difficulty saving for the future. Because of the aforementioned automaticity and invisibility, tax withholding is a particularly effective form of accumulating money (even if it is for zero-interest). It commits people to save money that they are sure to get once a year. For taxpayers with low or moderate incomes, this aspect of over-withholding is especially powerful. As economists Michael Barr and Jane Dokko point out:
“In light of high-cost financial and banking services, as well as barriers to saving facing LMI [low- to moderate-income] households, there is the potential for households to view the withholding system as a mechanism for saving. Their attitudes about the withholding system may reflect an awareness that they are able to save by overwithholding and subsequently receive a sizable (lump-sum) tax refund. Such households may also use the withholding system to restrain their consumption; overwithholding serves as a precommitment device against overconsumption.”
Like many other financial decisions, whether over-withholding taxes is a smart thing for you to do is a moot question. If getting a tax refund helps you sleep better at night or forces you to save a big sum which may be difficult otherwise, any embarrassment at giving an interest-free loan to the government is easily offset.
