The Hidden Cost of Tax Refunds

Tax refunds are awesome, unless they lead you to spend more than you can afford.

  • Share
  • Read Later
Getty Images / Fuse

Most of the nation’s 100 million or so individual filers of federal tax returns will get a refund this year—an estimated 75%, in fact—and for those lucky souls we have a message: Be careful; windfall monetary gifts can be dangerous to your financial health.The culprit is one of the most common decision making biases identified in the past four decades of research in the field of behavioral economics. It’s called “mental accounting,” and it’s a subject visited frequently in this blog. Mental accounting is the process by which the human brain, consciously or otherwise, labels and prioritizes money differently depending on where it comes from (paycheck vs. gift from grandma), where it’s kept (savings account vs. stock market), how it’s spent (home repairs vs. vacation cruise), or  size of transaction (we value a $5 discount on a $20 item more than same discount on a $100 purchase). This is often a very useful bias, in that people who otherwise have a difficult time saying no to a new pair of shoes, pricey dinner, or digital camera can nonetheless refrain from tapping into their kids’ college fund because they have mentally accounted for those dollars as sacred.

(MORE: The Next Big Thing in Corporate-Tax Avoidance)

But the problem with this non-conscious tendency to play mind games with how we treat money is that we sometimes aren’t aware of the rules. That’s especially true when it comes to the size of so-called windfall profits—in this usage, money that’s not part of your stable income stream, a.k.a., bonuses, gifts, gambling winnings, and, yes, tax refunds (expected or otherwise). Research suggests that if you get a $300 refund you’re more likely to make a $300 discretionary purchase with it than if you get a $3,000 refund—even though you can afford to splurge more, and still save a lot, in the second instance. (Up to a point, of course: Given a big enough windfall, most people will splurge and save.) It seems that a larger amount of found money makes it more difficult to spend, serving to boost what economists call our “marginal propensity to save,” or MPS. Smaller windfalls, on the other hand, increase our MPC, or “marginal propensity to consume.”

But the latter tendency is even more devilish than it seems. This was notably shown, as I’ve written before, by the economist Michael Landsberger in a well-known 1966 research paper. Landsberger studied a group of Israelis who were receiving regular payments from the West German government after World War II. Intended to partially make up for Nazi atrocities, these payments were, in effect, bonus money, in that they usually augmented other more traditional forms of income. Because of this aspect, and because payment size varied significantly from one “survivor” to the next, Landsberger was able measure the effect of  windfall size on each recipient’s spending rate. His results were eye-opening: People whose payments represented the largest chunk of their regular income had an MPC of about 0.23; that is, they spent 23% of their bonus payments, saving the rest. Meanwhile, the group whose payments represented the smallest portion of their regular income, had an MPC of 2. That’s no typo: For every dollar of found money, these folks spent two dollars—$1 of found money and another $1 from “savings,” i.e., what they had previously saved or what they might have saved had they not spent it.

(MORE: Guidelines for Electronic Tax Receipts)

For whatever reason, small windfalls were mentally accounted for not only as eminently spendable, but as spendable over and over again! If this sounds unbelievable, consider the following story about about a friend, whose tale I first told in the book referenced in my author’s bio. My friend, “Gideon” (not his real name), worked overseas for a small U.S. company. While on vacation in the U.S., he stopped by his employer’s Manhattan headquarters and, to his surprise, received a $400 bonus. A splendid gift, he thought, until he realized at the end of his trip that he had spent that $400 five times! Basically, every time Gideon went into a store or restaurant, he and his wife used that bonus to justify spending more money, i.e., “What the heck, we have $400 more to spend than we thought we had!”

Put another way, that bonus was a gift horse whose mouth deserved to be inspected.

Which brings us back to tax time. For filers who are expecting a refund, beware the tendency to treat small checks—like obscenity, you’ll know it when you see it—as license to spend (and spend and spend…). For filers who aren’t expecting a refund, be doubly cautious. Research shows that unanticipated windfalls are even more easily spent than anticipated ones. Luckily, mental accounting can be “gamed” to help in either situation. People tend to treat newly discovered savings more cautiously than windfalls. That is, we’re likely to spend a $1,000 tax refund more easily than $1,000 in a long-forgotten bank account. (Which is curious, since a tax refund is simply Uncle Sam returning your “deposit” to you, minus interest.) A helpful strategy, then, is to promise oneself to refrain from spending any part of a refund (or other kind of found money) for a brief but significant period — two months, say. That’s easier than committing to saving all of it, but the happy result is that eight weeks later you’ll likely have started to mentally account for your found money as actual savings, part of whatever long-term account in which it was deposited. If that turns out to be the case, you might just decide that this particular gift horse is better off staying in its stable.

3 comments
mrthanhden
mrthanhden

So this is brilliant way to pay tax? Finance is for big guy play together..any tax advice?

notLostInSpace
notLostInSpace like.author.displayName 1 Like

What I find amazing is how many people, 75% (?) are so willing to give substantial free loans to the government.  I have run payroll departments for years and find so many people non aggresive in their withholding strategies.  Then I wonder how many of them are the same people that want to gut the government (they could help by not giving a free loan!).  I find instead it is a free loan FROM the government to have high witholdings and owe tax at tax time.

John
John like.author.displayName 1 Like

@notLostInSpace  

I have my taxes prepared, not because I have a lot of money, but because I just got tired of messing with the Feds everchanging rules.  I try to not have a big refund or have to pay a lot at the end of the year - in other words I would like to both receive zero refund and pay nothng at the end of the year.  If I pay too little I get a notice to start paying quarterly. My tax man tells me to ignore the notice and pay the penalty. We then increase the withholding to fit the situation above, instead of getting a refund of what was my money IN THE FIRST PLACE.