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Inertia and Overwithholding: Explaining the Prevalence of Income Tax Refunds

  • Damon Jones
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    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.

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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15963.

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    Date of creation: May 2010
    Date of revision:
    Publication status: published as “ Inertia and Overwithholding : Explaining the Prevalence of Income Tax Refunds,” American Economic Journal: Economic Policy , 4(1), February, 2012: 158 – 85.
    Handle: RePEc:nbr:nberwo:15963
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    1. Looney, Adam & Kroft, Kory & Chetty, Raj, 2009. "Salience and Taxation: Theory and Evidence," Scholarly Articles 9748525, Harvard University Department of Economics.
    2. Brigitte C. Madrian & Dennis F. Shea, 2001. "THE POWER OF SUGGESTION: INERTIA IN 401(k) PARTICIPATION AND SAVINGS BEHAVIOR," The Quarterly Journal of Economics, MIT Press, vol. 116(4), pages 1149-1187, November.
    3. Naomi E. Feldman, 2010. "Mental Accounting Effects of Income Tax Shifting," The Review of Economics and Statistics, MIT Press, vol. 92(1), pages 70-86, February.
    4. Douglas Bernheim & Antonio Rangel, 2007. "Beyond Revealed Preference Choice Theoretic Foundations for Behavioral Welfare Economics," Discussion Papers 07-031, Stanford Institute for Economic Policy Research.
    5. Stefano DellaVigna & Ulrike Malmendier, 2006. "Paying Not to Go to the Gym," American Economic Review, American Economic Association, vol. 96(3), pages 694-719, June.
    6. Abadie, Alberto & Gay, Sebastien, 2006. "The impact of presumed consent legislation on cadaveric organ donation: A cross-country study," Journal of Health Economics, Elsevier, vol. 25(4), pages 599-620, July.
    7. Daniel Feenberg & Elisabeth Coutts, 1993. "An introduction to the TAXSIM model," Journal of Policy Analysis and Management, John Wiley & Sons, Ltd., vol. 12(1), pages 189-194.
    8. Raj Chetty & Emmanuel Saez, 2009. "Teaching the Tax Code: Earnings Responses to an Experiment with EITC Recipients," NBER Working Papers 14836, National Bureau of Economic Research, Inc.
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