Inertia and Overwithholding: Explaining the Prevalence of Income Tax Refunds

Every year 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 and in some cases may hinder consumption smoothing. 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 …nd that tax …lers only partially adjust tax prepayments in response to changes in default withholdings or tax liability. I use four di¤erent settings for identi…cation: (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 …rst two cases, I …nd that individuals o¤set less than 30% of a shock to the refund level in the …rst year, and less than 60% of this shock after three years. Adjustments in tax prepayments by EITC recipients o¤set no more than 2% of the change in tax liability. In the case of the Advance EITC, I show that informational interventions have the potential to greatly reduce default e¤ects. 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 a¤ect consumption smoothing, particularly for low-income tax …lers. JEL Classi…cation: D14, H24, K34 Stanford Institute for Economic Policy Research, Stanford University and University of Chicago, The Harris School, 579 Serra Mall, Stanford CA, 94305, [email protected]. I thank Emmanuel Saez, Ulrike Malmendier and David Card for research guidance. I am grateful for additional feedback from Alan Auerbach, Raj Chetty, Stefano DellaVigna, Jim Hines, Patrick Kline, Botond Koszegi and Bruce Meyer.