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If you’re looking for a real-world laboratory to understand “behavioral finance,” then tax season might be the perfect choice.
Behavioral finance is the broad term used to describe just how irrational humans can be, especially how our emotions and biases influence our choices in personal finance and investing.
Adam Smith (the father of economics) assumed that people would behave rationally in their own best interests. Behavioral finance begs to differ.
As we approach the April 15th tax deadline here in the US, I’m seeing some fun examples of behavioral finance in the tax world. Let me share some examples with you.
The Framing Effect
Lots of people love tax refunds and hate owing more in taxes. One is receiving money. The other is paying money. Surely receiving money is just better.
But is this rational?
Your total tax bill is a function of your income streams, your deductions, and your tax credits. Throughout the year, most of us pre-pay our annual tax bill via withholding. With each paycheck, a portion is withheld to pay taxes.
Then, when you “do your taxes,” you plug in all your numbers to see if your withholding throughout the year actually covered your tax bill in full.
If you withheld too much, you get a refund.
If you withheld too little, you owe more.
But in either case, your total bill is identical! The refund vs. owing is simply a way to correct your withholding, which is rarely ever spot on.
Example:
- A couple filing Jointly with $200,000 in adjusted gross income would have an Federal income tax bill of ~$27,000
- If they withheld $30,000 throughout the year, they would receive a $3000 refund after filing their taxes.
- If they withheld $25,000 through the year, they would owe an additional $2000 after filing their taxes.
- Anyway you cut the cake, this family paid $27,000 to the IRS
The love of refunds and the hate of owing more…is irrational!
Mental Accounting
Mental accounting is a term coined by Nobel economist Richard Thaler. It occurs when people categorize and track financial decisions by assigning money to subjective “accounts” based on its source or its intended use.
For example: “I just got my tax refund – free money! – so I’m going to go out and buy some Lotto tickets!”
Remember: money is fungible.
Whether it came to you via a paycheck or a tax refund or a gift from grandma…
Whether you need it to buy baby formula or a new pair of basketball sneakers…
The source or intended use of a dollar shouldn’t be a reason to treat it carefully vs. carelessly.
Loss Aversion
Loss aversion is simple. For most people, the pain of loss is a stronger emotion than the joy of gain. Therefore, we tend to avoid losses more than we pursue equivalent gains.
In the world of taxes, this is why many people choose to over-withhold throughout the year and then get a big refund come April.
Owing money in April feels like a loss. Getting a refund feels like avoiding that loss…even though it’s inefficient. So people over-withhold to avoid that pain.
The Endowment Effect
The endowment effect describes how people will over-value an object they own simply because they already own it. Usually, some sort of emotional attachment leads to the owner overvaluing their own possessions.
Example: a group of people who own a particular watch would be willing to sell it for, on average, $300. A different group of people shopping for used watches would be willing to pay $100, on average, for the very same watch. Those who already own the watch overvalue it compared to what the market would be willing to pay.
I see the endowment effect interact with taxes via tax policy.
Whenever new tax policy is passed, it usually comes with some good and some bad for taxpayers. More taxes here, fewer taxes there. This new deduction, removing that old deduction.
The bad news (e.g., taking away a tax break we were previously benefiting from, that we “owned”) is almost always met with contempt and anger. Those bastards!
Meanwhile, good news (adding a tax benefit we hadn’t had before) is mild. Oh…ok yeah that’s neat.
Anchoring
Anchoring bias occurs when the first piece of information we hear affects us more than it should. That information “anchors” us to a spot, and we don’t allow new/better information to move us from that anchor.
If I received a $2500 refund last year, and only received a $600 refund this year, I might wonder what the heck happened?!
I’m anchored to getting $2500. Seeing that number drop to $600 feels…bad, confusing, unjust!
But it shouldn’t.
Maybe your bigger tax circumstances changed. Maybe you adjusted your withholding throughout the year, and the $600 refund is purely better than the $2500 refund.
Status Quo Bias
Status quo bias is a simple bias to keep things as they are and resist change, even when objectively better alternatives exist.
It’s often considered a cousin of Loss Aversion, because people overvalue the certainty of the current state and fear the risks (losing!) associated with change.
Taxes change over time. When you get married, have kids, change jobs, get a promotion, invest more, approach retirement, actually retire, etc. etc. etc…your approach to taxes should change. It’s a good thing!
But for many, the status quo feels safer.
Identity and Fairness
If you want to raise someone’s hackles, present them with something unfair or that questions their self-identity. Tax scenarios can do both (whether it’s rational or not).
WOOF WOOF WOOF!
Taxes are one of those interesting issues that span economics, politics, philosophy, and morals.
Are we paying our fair share, or are we subsidizing freeloaders?
Are these dollars paying for school lunches and firefighters, or for bombs being dropped on far-off places?
Many taxpayers feel some combination of:
- I pay too much and others don’t pay their fair share.
- I don’t want some government deciding how to spend my money. Taxation is theft.
Whether these beliefs are right or wrong, they certainly influence behavior.
I know taxes aren’t fun.
But the more rationally we view them, the better off we’ll be in the long run.
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