Can the tax code cause us to spend too much?
April 15th – Tax day is upon us, so it’s a perfect time to contemplate a few aspects of taxes.
In the past I’ve written about how I used to think that tax day was a wonderful day of civic engagement – a day to think about how much we make and contribute, what taxes we pay and what services we get in return. Of course, over the years, as my taxes have become more complex, this task becomes one that is less about civic engagement and thoughtfulness, and more about annoyance and frustration. But that’s for another time.
Today I want to talk about the fact that the US tax system makes it very difficult for us to understand how much money we make and how this may actually lead us to spend more money than we really have. Think about it for a moment—do you know your net monthly income? I suspect you don’t, and I think that the tax system is to blame.
In many other countries, the tax code does not allow for the same level of deductions we have, and because of that for most people the whole amount of taxes is automatically deducted from their paycheck – and this is it. Now, in this situation when you ask people how much they earn [and yes, in other countries people do actually ask each other what they make] they will tell you their net monthly income – the amount of money that they get to take home at the end of each month. How do they know? Well, it is the number that is printed in bold letters on their paystub.
Contrast this to the US. In the US, we all know the gross amount that we make a year, but it’s not as clear what our net income is. It’s actually very complex because we get our salary, some of which the employer withholds, and we have no idea what we’ll get back when tax day comes around. We can get back some money (depending on our expenses/deductibles), trends in our stock market portfolio, health care, etc. And we don’t figure this out until April 15th (if not later) of the following year!
And what are the consequences of knowing our gross yearly income and not much else? I think it causes us to feel richer than we really are and spend accordingly. Why would this be the case? There’s a phenomenon we call the “illusion of money,” which is the idea that we typically pay attention to nominal amounts of money rather than real amounts. For example, the illusion of money means that if inflation is 8%, and you get a 10% raise, you would feel better than if there was no inflation and you got a 3-4% raise. The basic idea is that we pay attention to the nominal amount rather than the purchasing power, and don’t realize what our money is really worth.
In terms of our tax code, this suggests that in the US we focus on our gross yearly income, feel richer than we really are, and consequently end up spending more money. If this is right, it means that changing the structure of deductions could be one way to help people understand how much money they actually have and how they can save more.
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Well yes. As someone who lives in one of these “other countries”, doing my taxes as I recently did consisted of logging in with a code, looking through the numbers, clicking the “confirm” button. That’s it.
Although, a small observation: at least here, if you ask someone what they make, the answer will most likely be the gross income.
I love your work Dan but I do disagree with the idea that we spend more than we make because we don’t know how much we really make. I think it’s simply that we live in a consumer driven society. For so many people getting the latest iPad or iPhone is never a consideration of money, just desire. It’s the latest, greatest and that’s all that matters to people. And it’s not limited to cool technology. People spent WAY too much money on homes they could not afford prior to the housing bust in America. When credit flows freely people don’t consider the consequences of spending because it’s a future obligation.
Or, we could move to a consumption-based tax (i.e. sales tax) for individuals (not necessarily for corporations). With very low or no tax on staple foods and modest rates on all other materials, products and services.
Employees would receive their gross income and pay as they go at the register. It would be easier to understand and it’s already familiar to us so there’s little-to-no learning curve.
Is there a down side? It would eliminate quite a few jobs (tax preparers, IRS agents, etc) but I do not view that as a down side.
josephmartins: the big down side is that with no or low taxes on basic consumer goods, tax revenue would fall drastically, because there is no way that higher sales taxes on luxury products would make up for the general loss.
And if there’s a noticeable sales tax on basic consumer goods, this tax reform becomes EXTREMELY regressive.
I wrote no or very low tax *on staple foods* D (e.g. corn, potato, rice, wheat, sugar etc) not on all *basic consumer goods* (whatever that is supposed to mean). I made that suggestion because a tax on staple foods would likely do the most harm to the poorest members of society.
Furthermore, I’m not talking about maintaining the current sales tax rates while eliminating income tax. Nor am I talking about a change in payroll taxes, corporate tax, excise tax or any of the other sources of tax revenue–just income tax.
Obviously an increase would be needed across the board–some “experts” estimate it would require sales tax rates north of 20%–but it’ll be much easier for consumers to see and understand.
According to The Dept of Labor’s 2009 consumer data there are nearly 121 million “consumer units” (i.e. families averaging 2.5 people and 1.3 earners) in the US spending and average of roughly $50k annually each on goods and services.
Some oversimplified economics/math and a host of assumptions reveals that a 20% sales tax on most goods and services would yield roughly $1.2 trillion in tax revenue–a figure virtually identical to the $1.2 trillion in individual income tax collected in 2009.
Frankly, it’s more of a psychological obstacle than anything else. A bogeyman used by people who fear change, and the often challenging, complicated, imperfect decision-making required to lay the foundation for positive long-term change. What might seem extremely regressive to you in the short term, may be precisely the long-term change this country needs.
And to tie this back into Professor Ariely’s post, I strongly believe such a change would eliminate any illusion we have about our incomes. And in my mind, that would be a good thing.
I mean regressive as in the opposite of progressive taxation: poor people will end up paying a larger portion of their income than rich people.
It’s fairly simple, everyone has to eat, and people can’t sustain themselves on potato alone, or rather shouldn’t be expected to. If you earn less, a larger portion of your paycheck will go towards food, clothing and other essentials (what I meant with basic consumer goods). Since the money you spend on these goods will be taxed the same rate for everyone, you’ll end up paying more taxes as a proportion of your total income than your richer neighbor will.
D,
We all imagine a “better life”. As kids who grew up in the projects in a low income family my siblings and I know the feeling. When we ate Ramen noodles we wished it was spaghetti and meatballs. On the occasion that our parents bought fresh meat by the pound they probably wished they could afford to buy it in bulk for half as much. We did have to eat. So we ate what we could afford to eat in the way we could afford to eat it. Years of pasta, potatoes, rice, cereal, peanut butter and milk.
You wrote, “Since the money you spend on these goods will be taxed the same rate for everyone, you’ll end up paying more taxes as a proportion of your total income than your richer neighbor will.”
I’ve read similar comments many times. Perhaps, if my “richer neighbor” happens to have about the same taste that I have in food, clothing, vehicles, vacations, homes etc you’d be right. However, my neighbor’s tax contribution scales with consumption and cost.
Will the neighbor who purchases $15 shoes and $40 dresses pay as much sales tax as the one buying $50 shoes and $100 dresses? And will either of them pay as much as the one buying $1000 shoes and $10,000 dresses? Will a neighbor who buys a $1500 used car pay as much as one who buys a $25,000 car? Will either of them pay as much sales tax as the one who buys a $250,000 car? Will the family that pays for professional monthly lawn care services, gardening, dry cleaning, nanny services, financial management, golf lessons, tennis lessons, manicures, pedicures, private school, home remodeling, auto detailing, and maid services pay as little consumption tax as the family who does much of this work on their own or not at all?
My original statement seems fair as far as I can tell. The more you consume, and the higher the cost of the goods that you buy, the more tax you’ll pay. A simple, modest consumption tax would very likely bring in at least as much revenue as the current archaic, confusing boondoggle system we use today, if not more (considering the potentially large operational savings to the government).
Would it “hurt” lower income families more? Frankly, I don’t know and I haven’t seen data to support it. I do get the feeling our “richer neighbors” are thoroughly pleased with the current tax system and the tax breaks/loopholes they leverage that others cannot. There are only two legal ways to hide from a sales tax: reduce consumption or buy less expensive goods.
While I understand fully the concept of the “money illusion,” I’m not sure I buy into it 100%. Being a few years out of college, a majority of my monthly expenses are fixed debt payments (mortgage, car note, student loans, etc). If I get a 10% raise I can pay the fixed-rate loans faster without consequence, and I can maybe pay the variable rate loans faster than the interest rate rises. Clearly I am better off than if I had gotten a paltry 3-4%.
Maybe I have been illusioned? (illused?)
This is exactly why inflation is good for debtors and bad for creditors (aka banks), and why the Federal Reserve Bank, which wrongly sees the banks as its chief constituency (the US people as a whole should be), will and does adopt monetary policies which keep millions out of work in order to prevent inflation from rising. Even right now, the Fed could be reducing unemployment significantly by printing money, but refuses to do so because it could raise inflation even slightly.
Thank you – very thought provoking. In addition, when loan applications are considered, it’s the monthly GROSS income that’s taken into consideration of the debt-to-income ratio – I wonder how many people would have taken on the large mortgage payment had the net income been considered instead.
I do agree that there is a great psychological aspect to spending more money than we make. I would think living beyond one’s means is a cultural and societal trait rather than stemming from a tax system. For instance, Americans are world famous for being the fatest people in the world but has nothing to do with a unique supply cheap high choloric food. It’s available in any first world country in the world.
One reason we buy things we can’t afford is the same way Chinese people order more food than they can possibly eat at a restaurant. It’s Coolidge’s looking glass self in effect, to be perceived as more affluent or more successful than we are.
I would be interested to see a study on this particular predictably irrational behavior. To prove your theory, control groups can be given “credit” in a game, one group spends based on gross income with unkown deductions and other on known net income values. Will the difference be statistically significant across cultures or the same regardless of geography or ethnic background?
When I was a salarywoman, and particularly before I bought a house, my gross-vs.-net numbers were pretty easy to track. It’s been 30 years since I had a paycheck from DukeU, but back then, and at every employer since, the Gross and Net amounts were printed on the check. Funny, too, but the bank never noticed Gross and only deposited Net.
My tax obligation didn’t make all that much of a difference–for example, even a $1000 refund (and that would be high in the days before home ownership) (not engaging in the “size of refund” debate here) is only $41/paycheck. I wish I could pretend that my credit card problems are/were due to a $41/check misunderstanding of gross vs. net. But no–that’s not where the problem lies for me.
My taxes are more complicated today because I have chosen to diversify my income streams. Those income streams create their own obligations–managing rental property, for example, or royalty payments (Ha! $25 year…). I can hardly blame the tax system for “obscuring” gross v. net income when I’m the one who elected to become a landlord, and write a book.
The problem with the “illusion of money” and a 10% raise is that, if and when inflation changes (and it does), the guy who got the 10% raise is 6% ahead, for life, over the person who only got a 3-4% raise in a time of low inflation. Most US businesses will limit the max raise or require many more layers of management approval to give larger %ages, so the person who only got the 3% raise is forever behind.
401K matches are based on %ages, too, so the guy with the higher total number gets more in the match.
It’s compounding at work, rather than merely an “illusion.” (I recognize both players in this example should be subject to the same inflation rates at the same periods, so my example’s flawed.)
Bonuses also contribute to the illusion. I do all my deductions based on expected income, 401K and FSA deductions. Given the direction in which I tend to err I always get a refund.
At the end of the year I got a bonus. Hip-Hip Hooray! But, based on the increase I for the first time *ever* I owed taxes.
Fortunately, I’m very disciplined when it comes to money. I didn’t “count” on a refund (I just can’t spend money I don’t have in hand) and it always goes right into savings. I used a small portion of the bonus to buy designer jeans. The rest, you guessed it, right into savings.
Someone with a different attitude might have spent more of the bonus under the guise of “I didn’t plan on having this” and counted on a refund to cover an upcoming expense. So much for hip-hip hooray.
Your books give me a start. Money and arithmetic is quite a cause for denial overall. I keep asking everyone I know this (I may write a third book-”eating on $1″ in Amazon is first http://amzn.to/cwLjzE I get someone and say. So the lottery takes in 100 million and taxpayers keep 50 million. So when you spend $1 that means the State gets 50 cents – right? There are two cultures science/technology and everyone else. And the everyone else is politicians the media and most writers. This is the most basic foundation of math I can think of. Why is it so hard for people to understand? I am not writing the book until I grasp – “Why do people bet on the lottery?” Why can’t they grasp this simple “story problem?”
im one of those weird people who actually knows what their net income is. every year i make my best effort to hit zero at tax time… zero owed, and zero refund. ive never hit it exactly, but i come awfully close. this year was the closest yet: i received a refund of $14. my error was less than that of a cup of coffee every month.
it really ISNT that difficult to figure out. you just have to plan ahead, and make the effort to understand the tax code. for the record, no, i dont file a 1040ez. i fully itemize every year… it IS possible, even with a reasonably complicated tax situation. its YOUR money, you have a responsibility to know where it goes and how it is taxed, and if you fail to do that… well. i guess youll have problems. whether or not the tax code SHOULD be so complicated and require such an effort is a topic for a different discussion… it is what it is.
naturally, there will be things from time to time that are genuinely unforeseen and cannot be planned for that will affect your taxes at the end of the year, but it is rare for those things to affect them MUCH. and on the rare occasion that they do have a large effect… well, those things would be a rather large surprise regardless of how the taxes are figured or collected.
Are you self-employed? Filing quarterly tax estimate payments? Those of us with employers have only a very large-grained tool (the number of deductions on the W4(?) we fill out for the employer) to control how much the employer withholds. We have nowhere near the level of control to hit as close to the target as you do. And no one provides us any table to indicate how many deductions corresponds to how much withholding – it’s entirely guesswork, that we can adjust by trial and error only.
in fact, i am not… i dont do a standard w4… i specify a specific amount to be deducted on my w4. you dont HAVE to do the imprecise “N number of deductions” method…
Melissa-
Though I can’t claim to have ever hit within $14 at tax time, there is a fairly simple method to calculate how to adjust your withholdings.
At the IRS website (www.irs.gov), in the left sidebar, there is a link to the “Withholding Calculator.” I do this in July, but you can do it as many times as you want to fine-tune your balance come April 15.
Based on the numbers you enter, it will tell you what to put on your W4 (easily obtained from HR & adjustable as many times during the year as you are willing to turn one in) and if you are still coming up way off, you can enter a “flat” amount to be deducted, as radio_babylon recommended.
Happy estimating!
When I read an excerpt form this article in the paper this morning, I thought this has got to be a misprint. Certainly, he means that we know what our net income is, rather than our gross. It’s easy; it’s the number that is printed in bold letters on our pay-stubs. We know what our deduction will be too. It’s called the standard deduction. Most people do not itemize. We also have a fairly good idea of how much we’ll get back. I wonder if you even know any hourly workers. You seem oddly out of touch.
There is no ideal formula how to give to Caesar what is “from “Ceasar or Ceasar’s!
Net income ,or “omnia mea mecum portat” is the base of individual and social security and predictivity.
The sort of actual or future society is positevely in correlation with net and “variably “with wishful income .
The problem is what about motivation and wishful thinking as the producing force?We may admitt that they are rarely in correlation with net-incomes.
Distribution curve should be fair!
I wish to all of us super net income and full tax-box!
(Esop wrote something about how to satisfy the wolf with the goat alive)-