No Slack: The Financial Lives of Low-Income Americans

Paying to Save

218 In the United States, the Internal Revenue Service (IRS) collects taxes on earned income by requiring employers to remit a portion of the employees’ paychecks as a prepayment of the taxes owed at the end of the year. If the amount prepaid is greater than the taxes owed, then the employee has overwithheld and is entitled to a tax refund in the amount of the difference. Overwithholding occurs at many income levels and is a common phenomenon among low- and moderate-income (LMI) taxpayers. In 2004 over 20 million LMI taxpayers filed for approximately $35 billion in federal tax refunds and reduced tax liability (Internal Revenue Service 2005). Given an average refund of over $1,700 among LMI households, the economic implications of overwithholding are potentially quite large. Economists typically view overwithholding as welfare reducing and, therefore , undesirable as an individual decision as well as a policy. The withholding system changes the timing of income from what it would be if individuals paid their taxes in a lump-sum fashion at the end of the year. From the perspective of the permanent-income hypothesis, changes in the timing of income alone have no effect on individuals’ ability to smooth consumption under an assumption about perfect capital markets. Because the U.S. Treasury does not pay interest on the amount overwithheld, however, overwithholding lowers the present value of lifetime income and makes individuals worse off. It is through this margin that the withholding system is welfare reducing if the permanent-income hypothesis provides an appropriate model of behavior. If, in addition, individuals cannot Paying to Save michael s. barr and jane k. dokko 10 paying to save 219 borrow or are credit constrained, overwithholding exacerbates the liquidity constraints they experience during times of low income on both the extensive and intensive margins, and crowds out precautionary saving. In most economic models , the payment of interest on the amount overwithheld is welfare enhancing, all else being equal.1 Whether LMI taxpayers share the canonical view of overwithholding is unclear. On the one hand, many LMI individuals would benefit from having their refund distributed evenly throughout the year, particularly in light of the credit constraints and high-cost borrowing opportunities available to this group. Indeed, many LMI tax filers take out refund anticipation loans (RALs), and pay a nontrivial fee to a tax preparer, in order to expedite the receipt of a tax refund (Barr and Dokko 2006). On the other hand, in experimental and nonexperimental settings, individuals state a preference for increasing consumption profiles to flat or decreasing levels, even when the former correspond to lower present values than the latter (Loewenstein and Thaler 1989; Loewenstein and Sicherman 1991; Frank and Hutchens 1993; Neumark 1995). The explanation for this finding, particularly in the context of tax overwithholding, remains an open question. One methodological challenge to identifying whether individuals want to overwithhold, and why, has been the lack of appropriate data. Default rules, individuals’ inertia, and existing tax administration rules, among other things, militate against interpreting the actual occurrence of overwithholding, given by tax-return data, as evidence that individuals want to overwithhold (Gale 1998). In this chapter, however, we present a measure of taxpayers’ “preference for overwithholding” using a unique question administered in the Detroit Area Household Financial Services (DAHFS) study, a data set that we designed and collected through the Survey Research Center at the University of Michigan. This question asks individuals to express whether they want to overwithhold their income in a hypothetical scenario in which they must choose the time profile of how to receive their income and pay their taxes. In a sample of LMI tax filers, 69 percent report that they want to overwithhold their income. This unique question, combined with a rich set of covariates, allows alternative explanations for individuals’ preference for nonsmooth consumption profiles to be systematically addressed. These alternatives include individuals’ loss aversion and mental accounting (Kahneman and Tversky 1979; Thaler and Shefrin 1981; Thaler 1990), risk aversion, the possibility of negative personal discount rates (Mishkin 1981; Courant, Gramlich, and Laitner 1984; Loewenstein and Sicherman 1991), status quo bias, and self-control problems related to dynamic 1. Technically speaking, if the U.S. Treasury were to pay interest on the amount overwithheld, individuals might not be better off, since higher taxes would finance this endeavor. 220 michael s. barr and jane k. dokko inconsistency and the divergence between short- and long...