[Editor’s note: The IRS has delayed the deadline for filing tax returns until May 17, 2021, giving Americans an additional 32 days to contemplate the folly of the federal income tax system.]
Every April 15, an argument breaks out over the overall rate of taxation, the plethora of loopholes and deductions, and the dead-weight-loss caused by the complexity of the system itself. Seldom addressed, however, are the four ways the American income tax system takes advantage of people’s innate cognitive biases in ways that are harmful both to the individual taxpayers and to national politics. In other words, the federal income tax system is a behavioral economist’s nightmare.
1. Paying is painless.
In classical microeconomics, losing $10 is just losing $10. In behavioral economics, the “pain of paying” refers to the loss of happiness from the act of handing over money, which is separate from the reduction in happiness that comes with having less money in general. Every time we part with money, regardless of how small the amount, it inflicts psychological “pain.” Behavioral economists generally agree on this, and also that the level of pain varies greatly between different payment methods. Paying with a credit or debit card is less painful than paying with cash or by check, because nothing is physically leaving your hands and going into another person’s hands, so people tend to spend more when they use cards.
The least painful method of paying, however, is automatic withholding. This is how taxes are usually paid—they’re deducted from each paycheck before the money even gets to a bank account. Making payment with no action whatsoever on the part of the payer is the behavioraleconomic equivalent of a powerful anesthetic. It couldn’t be less painful—and that’s a problem.
Attention is a limited psychological resource, and people don’t feel the pain of payments they don’t notice—hence, all the subscriptions and memberships that many of us have but no longer use, or the efforts by the Trump campaign and NRCC to pressure donors into recurring donations. There is no reason to think that tax payments work differently. When people barely notice that they’re paying taxes, they don’t think of the tax money as their money, but rather as the government’s money, and they think less of where it comes from and how it is spent. If paying taxes was more painful, demands for accountability of how the money was used would likely be louder.
The most obvious solution would be to make individuals pay taxes without withholding, but this isn’t politically realistic—nor is it a solution without clear and obvious downsides (for example, the amount of tax fraud would go up dramatically as it would be easier not to pay). Instead, one way to connect taxpayers to their taxes might be to show them how much of their money has been spent on different parts of the federal budget.
The numbers involved in budget debates are generally too big for the average person to fully comprehend. It’s all millions, billions—or increasingly trillions. That might change if, after each taxpayer filed a tax return, they received a statement showing how much they personally contributed to everything from the defense budget and Medicare to foreign aid and scientific research. The statement could show both how much an individual contributes per year and per month. Ideally, taxpayers would receive this “receipt” every month as a reminder of the costs of various government programs.
2. Filing is painful.
The average American spends 11 hours preparing their tax returns, and few if any countries make it as difficult as the U.S. to file taxes. This burden is unnecessary for most people, as the government already has all the information it needs to estimate most people’s payments. That is how it’s done in most Western countries. Sweden sends its taxpayers returns that are already filled out. The taxpayer’s only job is to confirm that the information is correct (i.e. that there aren’t any additional incomes or deductions that the government didn’t know about). Most people can do this in a matter of minutes.
Making it difficult to file taxes doesn’t incentivize paying taxes. If anything, it incentivizes taxpayers to try to wring every last cent out of their 11 hours of paperwork by looking for as many deductions as possible (even ones they may not technically be eligible for). Worse, the risk of making mistakes increases the more time and energy is spent.
Of course, what works for Sweden wouldn’t necessarily work in the United States without significant changes, but considering that two out of three American taxpayers don’t itemize in the first place, a European-style system might work for most American taxpayers.
3. Tax refunds create an illusion of government generosity.
A tax deduction is not a gift from the government, but rather taxpayers’ own money that the government has borrowed as an interest-free loan. Whether by design or by coincidence, the government is effectively tricking taxpayers into thinking of deductions and refunds as bonuses rather than as loan repayment.
At no time was this more obvious than in 2019, when many Americans received lower tax refunds than they were used to. Hashtags like #GOPTaxScam were trending on Twitter due to people mistakenly believing that the Trump tax cuts had raised their taxes. A taxpayer with a total tax bill of $12,000 prior to the tax cuts who paid $1500 per month received $6000 refund, ceteris paribus. After the tax cut, their total tax bill might have fallen to $10,000 with a monthly payment of $1200. Their new refund is just $2000. Their tax burden is lighter, but because the refund is only a third its former size, it feels like they’ve lost money.
Automatic withholding is important for the treasury’s cash flow, but it’s still possible to remind people that their monthly payments are actually loans—by treating them like loans. Paying interest in line with the 10-year bond yield would not cost much at all for the government, nor is the interest high enough that taxpayers would be incentivized to deliberately overpay their taxes to get a refund (or a statute could make this illegal). The real effect would be to remind recipients that they are receiving a repayment of a loan, not a government-issued bonus.
Another reminder could come in the form of terminology. In official communications from the IRS and other government agencies, the refund ought to be referred to as a “tax loan repayment”, “government loan repayment,” etc.
4. Windfalls are hard to manage.
Last year, the average American tax refund was $2707, multiple times higher than in many other Western countries such as Canada, Ireland, the United Kingdom and Sweden. Nearly 137 million Americans received a refund.
A tax refund is a type of windfall: an unexpected, largely unpredictable income. Humans in general are terrible at dealing with windfalls, which is why lottery winners often go bankrupt within a few years.
Most people’s refunds are nothing like a lottery payout. But especially to the poorest Americans, it can feel like one. Americans with annual incomes below $25,000 receive an average tax refund of about $2100—effectively an additional month’s salary. Receiving a lump sum of several thousand dollars tends to encourage people to splurge rather than to treat the money as they would regular income and portion it out over the next 12 months, even though this money is really no different from a monthly paycheck (the only difference being that it was lent to the government). While each individual is of course responsible for his or her own spending, a system that annually afflicts a large portion of the population with “lottery winner syndrome” is abusing its citizens’ natural cognitive weaknesses.
Obviously, far from all low-income Americans use their tax refunds to splurge. Tragically, many of them are forced to regularly take on credit card debt and payday loans to cover everyday expenses, which then accumulate over the year and are paid back using the refund. These Americans are effectively forced to take on high-interest debt because they are forced to give a zero-interest loan to the government. Only once the government repays them are they able to settle their accounts, after which the cycle immediately begins anew.
Paying the earned income tax credit monthly rather than annually would be a good first step to ameliorating the problem. Allowing people to choose when they file their taxes whether they would like their refund (should they receive one) as a lump sum or as 12 monthly payments would also help, as many consumers are aware that they are bad at handling windfalls and would opt for the latter.
It should be noted that some taxpayers intentionally choose to overpay their taxes so as to automatically save money by loaning it to the government. Once the refund arrives, that money goes into their savings account and becomes that year’s savings. For taxpayers who struggle with self-control and who are aware of this weakness, this’s not necessarily an irrational behavior. But if the IRS were to emphasize that the tax refund is an interest-free loan, fewer taxpayers may choose deliberately to overpay.
Independent of the debates over what should be taxed, who should be paying taxes, and how much they should pay, the American tax system suffers from serious structural flaws that waste taxpayers’ time and encourage destructive economic behaviors. Unlike more controversial topics like taxes for the wealthy and corporations, it ought not to be difficult to find bipartisan solutions to these issues.