Inertia and Overwithholding: Explaining the Prevalence of Income Tax Refunds

42 Pages Posted: 10 May 2010 Last revised: 25 Sep 2010

See all articles by Damon Jones

Damon Jones

University of Chicago - Irving B. Harris Graduate School of Public Policy Studies

Date Written: May 2010

Abstract

Over three-quarters of US taxpayers receive income tax refunds, indicating tax prepayments above the level of tax liability. This amounts to a zero interest loan to the government. Previous studies have suggested two main explanations for this behavior: precautionary behavior in light of tax uncertainty and/or a forced savings motive. I present evidence on a third explanation: inertia. I find that tax filers only partially adjust tax prepayments in response to changes in default withholdings or tax liability. I use four different settings for identification: (1) a 1992 change in default federal withholding, (2) a panel study of child dependents and tax liability, (3) the expansion of the Earned Income Tax Credit (EITC) during the 1990s and (4) a change in default enrollment rules for the Advance EITC option. In the first two cases, I find that individuals offset less than 30% of a change to their expected refund after one year, and about 50% of this shock after three years. Adjustments in tax prepayments by EITC recipients offset no more than 2% of a change in tax liability, though evidence from the Advance EITC indicates that information can significantly increase responses. Given the evidence on inertia, the design of default withholding rules is no longer a neutral decision made by the social planner, but rather, may affect consumption smoothing, particularly for low-income tax filers.

Suggested Citation

Jones, Damon, Inertia and Overwithholding: Explaining the Prevalence of Income Tax Refunds (May 2010). NBER Working Paper No. w15963. Available at SSRN: https://ssrn.com/abstract=1601714

Damon Jones (Contact Author)

University of Chicago - Irving B. Harris Graduate School of Public Policy Studies ( email )

1155 East 60th Street
Chicago, IL 60637
United States

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