Wednesday, January 28, 2009

Witholding, refunds, and "Ego Management"

All our recent discussions with taxpayers about the fiscal stimulus bill leads me to ask the following question to readers of this blog:

Which would you rather have: an extra ten dollars each week in your weekly paycheck OR an extra $520 after the end of the year in next year's refund check?

If you are like most Americans, you would actually choose the second option.

Most taxpayers overwithhold. In fact, the average refund is about $2,000, which means that the average taxpayer is giving the government an interest-free loan of $2,000 each year.

The average taxpayer who is voluntarily overwithholding could give himself a "fiscal stimulus" in the form of a larger take-home weekly paycheck any time he or she wants, just by filing a new W-4 form with his employer.

For example, consider a single taxpayer who makes $10 per hour and works 40 hours a week. Assume that he has no dependents of his own and nobody else can claim him as their dependent, so he is entitled to one personal exemption on his tax return.

The IRS instructions will advise him to claim "1 allowance" on his W-4, but many people in this situation play it even more conservatively than the IRS advises, and claim "0 allowances" on their W-4. This practice decreases their weekly take-home pay by about $10, and increases their refund by about $500.

So any taxpayers in such circumstances who want to "stimulate" themselves right now has the option to do so right away, without waiting for Congress to pass any bills or for the President to sign them.

The fact is that most Americans don't want to do this--they actually prefer overwithholding and giving the government an interest-free loan, even though they may be borrowing at much higher rates on their own credit cards.

Traditional economic analysis has no explanation for such apparently irrational behavior, but the newer field of behavioral economics focuses exactly on such questions.

2005 Nobel Laureate in Economics Tom Schelling invented the term "Egonomics" to describe the study of such behavior. His seminal article, which is short, non-technical, and well worth reading, is Egonomics, or the Art of Self-Management in the American Economic Review, 1978, vol. 68, issue 2, pages 290-94.

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