Apr 18, 2023 - Economy

Tax refunds are perfectly rational, despite what economists might tell you

Illustration of a hundred dollar bill in the shape of a Rubik's cube

Illustration: Sarah Grillo/Axios

Is getting a tax refund irrational? Some economists would have you think so.

Why it matters: Tuesday is tax day; those who pushed filing to the deadline are just learning if they overpaid their taxes this year and are due a refund — or if they owe more money.

How it works: Put very simply, employees have taxes withheld by their employer from their paychecks all year long, while freelancers pay estimated quarterly taxes.

  • Those who already gave the government too much will get a refund. Too little, they'll owe.

The big picture: Some economists and personal finance types argue that the ideal move here is to withhold just enough to pay the taxes you owe — and that getting a refund is a sign you've failed, essentially giving the government an interest-free loan.

  • Almost a third of personal income tax collected by the U.S. government is later returned via a refund, notes a paper published last year by the American Economic Review that seeks to explain this "irrational" behavior.
  • Technically, that's a painful hit at a time when you can earn a relatively high interest rate on your savings.

Reality check: An awful lot of people ignore that advice, and pay in excess of what's owed, so they can get a "windfall" come filing season. And that's the way they like it.

Between the lines: What's going on here is fairly simple. First, most people would rather receive money via a refund than take the chance of owing money.

  • "[P]eople really, really hate having to pay money. They feel the pain of having to pay $100 greater than the pleasure of getting an extra $100," Bill Congdon, an economist, explained on Marketplace more than a decade ago.
  • If you factor in the psychological costs — particularly, the uncertainty over what you'll owe —  overpaying taxes "may be perfectly rational," writes Kathleen DeLaney Thomas, professor at the University of North Carolina School of Law in a more recent paper.

Of note: Even in studies where they tell people exactly what they're going to owe, so there's no uncertainty, about half would still prefer to get a refund, she told Axios by phone recently.

  • "There's a disconnect between the way economists, and tax lawyers to a certain degree, think about the tax system and the way people actually think about the tax system," she said.
  • To be sure: There are definitely some folks out there who get annoyed by a big refund, and Axios has heard from them.

The intrigue: There is a compromise possible here though there's no push for it in reality  the U.S. could pay interest on withholdings that are refunded.

The bottom line: "People find value in using their tax refunds as a forced saving device," economist Justin Wolfers wrote Axios in an email. "If the money were readily available, they might spend it. This way they can get a big check from the government and put it toward making a big purchase."

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