It’s April 17 here in the U.S. meaning that the tax deadline has come and gone.
If you’re like most Americans, not only did you get a pretty big refund — $2,800 was the average the last time the IRS checked — but you’re pretty happy about it too. A Bankrate survey found that a majority of respondents would prefer to receive a refund rather than breaking even or having to cut a check to the IRS come tax time.
All this is still the case despite years of advice from journalists — including here and here — and all the finance experts in your life, telling you the rational reasons why a rational taxpayer absolutely shouldn’t want a tax refund.
But perhaps the real problem is that this advice fails to take into account how real people actually act instead of theorizing their shortcomings away.
By looking into the practical effects of an infrequently cited economic concept (exciting!) we might see these refund-seekers to be pretty rational after all.
Why getting a big tax refund is supposed to be a bad idea
The thinking is based on a couple economic concepts.
The simpler of these two concepts is the time value of money.
Read even a bit of the literature on the topic and you’ll almost certainly hear your tax refund referred to as an interest-free loan (Including in the two articles I linked to earlier). The math is pretty simple here; had you adjusted your withholding by submitting an updated Form w-4 to your employer, you could have traded the $2,800 refund you received in April 2015 for $233 every month from January to December 2014. Had you saved every last penny along the way and stuck that in a saving account to earn interest, you would have ended up with an extra $20 come April 2015. Had you invested that money in the market, you might have ended up with hundreds in extra money.
Generally, the hypothesis predicts that a rational consumer will base his or her current consumption on permanent income — that is, a combination of their current income and their expectations for future income.
Specifically, because the size of a tax refund is a largely predictable one-time surge in income, a rational consumer would not change their spending habits whether they got all of it in April 2015, or received it in small chunks spread out from January to December 2014.
What the theory gets wrong when it comes to refunds
The problem is that, in practice, taxpayers treat refunds differently from money distributed to them throughout the year.
Expectations of a tax refund may encourage saving
A study by Nicholas S. Souleles found that for each additional dollar of refund received, the average taxpayer increased consumption by the significant, but still pretty small amount of 18 cents, with the overwhelming majority of that added sensitivity being focused on the purchase of durable goods (such as refrigerators and bicycles). Souleles suggests that the reasoning behind this may be premeditated — taxpayers who understand their own limitations with self-control purposefully and rationally withhold too much in taxes so that they might be able to save up. (Source: Nicholas S. Souleles. “The Response of Household Consumption to Income Tax Refunds.” The American Economic Review, 1999.)
Taxpayers who receive large refunds may be more likely to save it than if they received it in smaller flows throughout the year
Richard H. Thaler points to several studies (including Japanese workers who save more of semi-annual bonuses, and Israelis who save more of restitution payments) that imply this outcome, which he explains as mental accounting on the part of consumers, concluding that “small gains relative to income, will be coded as current income, and spent” while “larger gains will enter the assets account, where the [marginal propensity to consume] is lower.” In other words, the larger the windfall a consumer receives, the more likely they are to save rather than spend it. By extension, you’re more likely to save more of one big lump sum you receive in April than smaller flows throughout the year.(Source: Richard H. Thaler. “Anomalies: Saving, Fungibility, and Mental Accounting.” Journal of Economic Perspectives, Winter 1990.)
A super-majority of taxpayers plan to use their refund to boost their net worth
This desire is echoed in consumer sentiment; only 3% of Bankrate’s survey respondents plan to splurge on something similar to a vacation or shopping spree, while 26% plan to spend it on necessities, including food and utilities. Encouragingly, A whopping 67% of taxpayers receiving a refund plan to use it to pay down debt, save, or invest.
Now, let’s be clear; the optimal outcome is to receive no refund (or even to owe money) and to save every last extra penny you get during the year in an interest bearing account.
But if receiving a big refund at tax time helps you spend less throughout the year and encourages you to put more of it toward debt or retirement savings, then that sounds like a pretty solid silver medal to me.
Enjoy your weekend!