Monday, January 27, 2020

Tax Refunds: CDs with a Positive ROI, not "Interest Free Loans"

Tax Refunds: CDs with a Positive ROI, not "Interest Free Loans"
We're almost through January, so that means winter has set in, our resolutions are getting harder to stick to (or have bitten the dust entirely), and personal finance bloggers are trying to figure out how to get a few dollars of affiliate income from a tax prep software industry that has spent the last twenty years trying to keep citizens from filing their taxes for free.

You see, the IRS and the tax prep software agency struck a deal decades ago: the IRS would agree not to create its own free tax filing software, if the industry agreed to offer a free version to middle income and low income filers. Everybody wins, right?

Except the tax prep software industry apparently used a series of tactics to prevent people entitled to the free software, including a particularly disturbing approach targeting military service members, from actually filing for free.

Shady business practices aside, this is also the time of year we start hearing about how getting a big refund from the federal government is a mistake: a sign that you've just given the federal government 'an interest free loan'.

I've always thought that was a cheap insult, and one that seems ignorant of basic math, to boot. Jason Hull, one of my early blogging friends and just one of the sharpest minds in personal finance, explains just how much interest you're missing out on with this loan.
First, the average tax refund in 2010 was approximately $3,000. So, let’s say that you managed to nail your average tax return amount spot on and not send that $3,000 to the government. Assuming a 1% annual interest rate on your money which is compounded at the end of the month and that you manage to deposit that $250 ($3,000 divided equally by 12 months) at the beginning of the month, you’re talking about getting a grand total of…Drum roll please…
$16.22 in interest. Oh, pre-tax. Given an effective tax rate of 25%, you’re talking about saving $12.17.
Besides the fact that the people arguing against tax refunds seem to be ignorant of basic math, their framing also just happens to ignore the nuances of human behavior.

Let's go back to the example of the average tax refund being about $3,000. Why on earth should we assume that the average American, if we gave him an extra $115.38 every two weeks in his paycheck, would actually save all of it, in each of his twenty six paychecks?

Again, from Jason Hull's excellent post, here is what typically happens with our primitive brains if we increase our paychecks a bit, trying to avoid getting a tax refund:

YOU: “No. This is money we should be saving because we’re not giving the government an interest-free loan.”
YOU: “OK. Let’s compromise. $100 a month goes to bananas, and $150 a month to saving.”
YOU: “OK. OK. OK!!! Deal!”
And, poof, you just increased your cost of living by $1,800 for the sake of not giving the government an interest-free loan to save $12.17. You picked up pennies while dollar bills blew by your face.
Hey, some of you may be made of sterner stuff than I am and be able to save it all....
For the rest of us, it’s easier to have to say no to temptation one time a year than to have to say it 12 times a year or 24 if you’re paid twice a month."

That's the catch with giving ourselves extra money each paycheck, in a vain attempt to avoid giving the federal government an interest free loan. While logically, we know we should save or invest each of those extra dollars we now see every two weeks, doing so involves making a series of difficult-but-good-for-us decisions, without fail.

I don't doubt that some readers of this blog are able to do just that. But do we really think that the average person is able to save all of that additional $115 they're seeing every couple weeks? 

And to what end? To avoid a paltry amount in opportunity costs?

On the other hand, research shows that while individuals are often very bad at avoiding the temptation to spend throughout the year, they seem to be better at saving a tax refund they get once a year. As Nicholas Epley, Professor of Behavioral Science at the University of Chicago School of Business, explains, the reason why has a lot to do with how we frame the annual windfall as a tax rebate or refund:
"In particular, windfalls framed as a gain from one’s current wealth state (e.g., as a bonus) may be perceived differently than income framed as a returned to a previous wealth state (e.g., as a returned loss or rebate). Despite being objectively identical, a “bonus” describes a positive change from the status quo whereas a “rebate” subjectively describes a return to the status quo. If people evaluate income comparatively rather than absolutely, they may feel like they have more income to spend—and therefore be more likely to spend at least some of it—when it is described as a gain (e.g., as a bonus) than when it is described as a returned loss (e.g., as a rebate)."

Simply calling the money a refund, getting your own money back, has a positive impact on our behavior. We see the windfall as money we should have already had, so we're less likely to spend it than had it been framed as a bonus. (Indeed, Epley argues this framing of a rebate was potentially what muted the effectiveness of Bush era stimulus: simply by calling the $600 checks a "rebate", taxpayers were less likely to spend the money and stimulate the economy.)

In other words, framing matters. And it can be used to influence consumer behavior, often to our benefit.

In that vein, I'd like the personal finance community to consider dropping the fairly tired cliche of giving the government 'an interest free loan'. 

The opportunity costs are small and the average taxpayer is likely to do something positive with the money at tax time (like save it rather than spending it). If we're desperate for a metaphor, rather than saying the taxpayer is giving the government an interest-free loan, why not consider that the taxpayer is making payments into a CD? (AKA, a certificate of deposit)

It's money that the taxpayer can't get back for a set amount of time, just like a CD. It pays no real interest, just like a short term CD these days. But also like a CD, its real value is in locking up money for a set amount of time, and keeping the consumer from doing something else (bad) with it. Its value is in changing our behavior.

In that regard, it has a real, positive ROI. A CD, or a tax refund, gets us a better outcome than we'd otherwise see. We are more likely to save, and are more likely to save a greater amount, of that single windfall, than if we had to make twenty-six small decisions in a row.

I'm sure there are readers out there who think this is all semantics. And on some days, I'd probably be right there along with you, wondering what difference this sort of framing could really make. Who cares what we call this money?

But, we're human. The name of a product, the way something is described, it really does change how we feel about it. I love cheesecake but I probably wouldn't eat it as much if we called it "cheese pie". (And why shouldn't we call it a pie? It surely is closer to a pie, with its crust and filling, than cake, when you think about it.)

Still, there's something in a name. How we frame things matters, and likely has a larger impact on our financial behavior than we'd like to admit. 

So the next time you're discussing the tax refund someone got, don't give them a hard time about it. Applaud the fact that they're more likely to do something good with that money now, and maybe take them out for a slice of cheese pie to celebrate.

*Photo is from Images of Money at Flickr Creative Commons.

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  1. Semantics actually makes a huge difference in what we do with our money! At least it does in my experience. Timing also makes a difference for me.

    But ultimately, even if I KNOW I'll be responsible with an extra $12 or $120 a month or whatever it is (and I am), I would still prefer a refund because it makes me feel less bad than paying a tax bill does in the spring. Yes I like making interest on my money, BUT I like not having to fork over a big chunk of money at once in spring more. Much more. EVEN IF I HAVE THE MONEY! And usually yes, I do have the money. I bow to my monkey brain on this one. It's like risk aversion though I know it's not risk. I just hate paying huge bills and I hate the surprise that usually comes with the big bill because the money I already have on hand is mine mine mine and I don't want to hand it over. I'm mostly rational with my money but this is one point I am not. *shrug* I accept that.

    1. I'm right there with you, Revanche. We are going to owe this year and the feeling is not a great one. Like you, we have the money but I don't feel good about it.

      And, to boot, there's some evidence that I might have done better with a refund. That is to say, even as budget minded as we are, we likely spent a portion of that 'extra' money we put in our biweekly paychecks when we adjusted our W4s.

    2. Agreed, it is a weird thing for people to get up in arms about.

      And, yes, I think the people you know are probably getting better results with these refunds than they'd otherwise get.

  2. The 'interest-free loan' argument is so petty.

    And it's really hard to accurately predict how much taxes you actually owe.

    One benefit I think IS worth looking into is people who have debt. If they keep their money throughout the year, they might be able to pay off their debt faster.

    1. Agreed, Luxe. It's a petty argument used by people who can't really calculate opportunity costs.

      I hear what you're saying about debt repayment. I think it would be an interesting thought experiment to see if people would actually put the entire amount they got in extra paychecks to debt, or whether they'd end up spending some of it. Depending on how much they spent, they still might come out ahead.