The biggest surprise about the recent fallout over lower tax refunds is that anybody in Washington is surprised. People love their tax refunds. Psychologists and economists have been documenting this phenomenon for decades.
For some, a refund helps them save for a major purchase like a car. For others, the refund feels like a windfall that they might spend on a vacation. Still others prefer overpaying their taxes because they dread the uncertainty of a tax bill.
While tax refunds were, millions of taxpayers are still expected to see a smaller refund this year or no refund at all. That taxpayers would feel angry and blindsided by this was entirely predictable.
The tax reform bill cut taxes for most individuals, so why are some refunds shrinking? The reason is that Treasury changed the withholding tables last year. For many, this meant less withholding and slightly bigger paychecks.
But the increased pay may have been too small for people to notice. Refunds, on the other hand, are highly salient.
After the new withholding tables came out, the IRS warned taxpayers that they should check their withholding elections and fill out a new Form W-4 if they wanted to avoid a surprise tax bill. Presumably, the segment of the public that is stunned by their reduced tax refunds didn’t do so.
But this was also predictable. Another well-documented behavioral phenomenon is that people tend to stick to defaults. Taxpayers essentially had two options after Treasury changed the withholding tables.
One option was to work through a complicated IRSand fill out a new tax form. The other option was to do nothing and hope for the best. It’s not hard to imagine that a lot of taxpayers went for the second option. Others probably didn’t even consider their tax withholding until they filed their tax return this year.
Given what we know about human behavior and preferences for refunds, there was an easier and less politically costly way to implement the tax law changes. Treasury should have simply left the withholding tables untouched, and urged taxpayers to adjust their withholding if they wanted to reap the benefits of tax reform sooner.
This would have been a win-win. Those who were paying attention to the new tax law, and who wanted bigger paychecks immediately, could have made changes to their withholding. Those who did not want to bother would simply receive a larger than usual refund. This would have come as a surprise for some, but a pleasant one.
The approach Treasury took instead, which was to urge people to change their withholding to restore their old refund amounts, was a miscalculation. It assumed people pay attention to their taxes before they file their tax return, which for many just isn’t the case.
Kathleen Delaney Thomas is an assistant professor of law and director of the University of North Carolina School of Law Tax Institute.