00:00:00
Alex Reese-Jones: My understanding
of what's going on
00:00:01
is absolutely that people are
00:00:03
changing kind of the degree of
attention and effort they put in
00:00:05
to, say, pursuing deductions or
maybe pursuing evasion, although
00:00:08
I don't see that directly. - Right.
- Things like that. Yeah.
00:00:12
And so I think that is moving
around. I mean, in some cases
00:00:15
that's desirable. In some cases
it's not, right? So taxes, we
00:00:18
basically have two reasons for
taxing things.
00:00:21
- Welcome to <i>The Ripple Effect</i>, the
podcast that takes you on a
00:00:24
journey through the minds of
Wharton faculty. I'm your host,
00:00:27
Dan Loney, and in each episode,
we'll be diving deep into the
00:00:31
inspiration behind the
groundbreaking research that
00:00:34
Wharton professors have
conducted and exploring how
00:00:37
their findings resonate with the
world today.
00:00:40
Dan Loney: Well, did you know
00:00:41
that there's an element of
psychology in— that comes into play
00:00:45
when you think about how we
think about paying our taxes?
00:00:49
Especially when you look at
things like losses and gains.
00:00:51
Warden Professor Alex Rees-
Jones has taken a deeper dive
00:00:55
into this component of taxes,
and he joins me here in studio
00:00:58
to talk about it. Great to see
you again. How are you doing?
00:01:00
- Great to see you. I'm
00:01:01
doing great. How are you?
- Thank you.
00:01:03
What was it that first got
00:01:04
you thinking about
00:01:06
this component of
psychology in taxes?
00:01:09
Well, I mean, this is a little dated
now. But when I was in graduate
00:01:12
school in like, the late 2000
aughts, I was very interested in
00:01:16
behavioral economics, which is
an area of economics that's all
00:01:19
about trying to build more
models from psychology into the
00:01:22
way we do kind of regular
economics. And at that stage,
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that was a very well-developed
field, but it wasn't yet, like, as
00:01:31
successful as it could be,
because a lot of it was focused
00:01:33
on, say, small lab experiments,
and there weren't an enormous
00:01:36
number of demonstrations of this
stuff being really useful to
00:01:39
think about big economic
behaviors. And so a thought I
00:01:43
had is that, no, I think people
could be influenced quite a lot
00:01:47
by psychology when thinking
about taxes. And if that's true,
00:01:50
that would count as a big
economic behavior, and
00:01:53
understanding how to model it
better through psychology would
00:01:56
be really useful just for doing
regular economics. It turned out
00:02:00
to be right, I think. And
there's been many other examples
00:02:03
like that in the years since.
But that's what initially was my,
00:02:05
like, point of entry into the
field.
00:02:07
And so I mentioned at the top
that component of losses versus
00:02:10
gains. I know you wrote about it
in part about the losses
00:02:13
component, about how we think
about working the losses that we
00:02:18
have, you know, kind of in our
tax preparation every year.
00:02:21
Yeah. So, you know, let me—
00:02:22
let me summarize the
idea on how losses and gains are
00:02:27
mapped into it. I mean, the thing I
was trying to get at in this
00:02:30
study was how the idea of loss
aversion would play out in tax
00:02:37
settings. Now, the term loss
aversion sounds pretty general.
00:02:40
You know, you could imagine it
applying to a bunch of things,
00:02:43
but when behavioral economists
use it, they mean a very
00:02:45
particular thing, and they're
referring to this reproducible
00:02:49
finding that people seem to
value, slightly increasing a
00:02:54
gain, less than slightly
decreasing a loss. So, like, to
00:02:58
illustrate, let's say I'm
asking you how much you how much
00:03:00
you value a dollar that I'm holding.
00:03:02
And you think about it, and you
00:03:03
would hope you'd say, oh, $1 is
$1. I'll think of my value for
00:03:06
that. And then to put it in
different frames, I could say,
00:03:08
well, what if I already owe you
$10 so this dollar is getting
00:03:13
mixed in and turning 10 to 11.
Or I could say, what if you
00:03:16
already owe me $10 and so this
is turning you paying me nine or
00:03:21
10, into you pay me nine. And in
either case, I'm just giving you
00:03:25
an extra dollar. $1 is $1. But
the thing you see, very
00:03:27
reproducibly, is that people
care a fair bit more about
00:03:30
making the loss a little bit
smaller compared to making the
00:03:33
gains bigger. And you know,
that's not so surprising to many
00:03:35
people, right? Like, people—
people don't like losing. People
00:03:38
don't like losses. So what— what
would that matter for taxes? Or
00:03:44
what's a way that might matter?
So the reason I got to thinking
00:03:47
about this is there's a very
strong and natural gain-loss
00:03:50
framing inherent in most
people's tax experience. So come
00:03:55
every April 15th, when you have to
fill— fill out and submit your
00:03:58
tax forms, a lot of this is
going to be centered around
00:04:02
doing a kind of gain-loss
calculation, where the main
00:04:05
thing you're doing is going
through documenting all the
00:04:07
types of income you had over the
year and figuring out your tax
00:04:10
liability. - Right.
00:04:11
And that's
really what the point of this
00:04:13
really is. But the last stages
of it are going through and
00:04:16
saying, how much tax did I
already pay, say, through with—
00:04:20
withholding from your employer,
or estimated taxes, or something
00:04:23
like that. And then what's the
difference, the balance due? And
00:04:27
then based on that, I decide
how much money is changing hands
00:04:30
between me and the IRS. And so
if I go through this, and I'm
00:04:34
one of the 75% of people who
over-withheld over the course of
00:04:38
the year, whose employer kept
more taxes than they needed to, I
00:04:41
then determine, "Oh, actually, the
IRS owes me money." I face a
00:04:45
gain. Or I could be one of the
quarter of people who are under-
00:04:48
withheld, in which case I
determine, "Oh, actually, I need
00:04:51
to send a check to the IRS." Now
I owe the IRS money. Now, the
00:04:54
thing I want to think about is
how much you care about doing
00:04:58
something that changes your
total tax liability, let's
00:05:01
say by $1. You could again say $1
is $1, but you can imagine that
00:05:06
being in this gain or loss frame
could matter. That a person who
00:05:09
is looking at a refund of 500
bucks says, "I don't really want
00:05:13
to spend an extra half hour
looking for tax credits or
00:05:15
something like that." Whereas a
person who has to send a check
00:05:18
to the IRS, they might be more
motivated to find extra things
00:05:21
they could deduct or cheat a
little more, or any of those
00:05:24
types of things.
00:05:25
Is there a component of this,
then, that you think impacts the
00:05:28
collection process of the taxes
by the IRS?
00:05:32
Absolutely. Yeah. So, to just
briefly mention the finding
00:05:36
which will play into the
collection. I mean, the thing
00:05:38
that I find by looking at
distributions of balances due
00:05:41
that are reported is pretty
clear evidence that something's
00:05:44
changing as gains turn to
losses. And the way I
00:05:47
rationalize it is by saying it
looks like $34 more money, like,
00:05:52
gets taken off your tax bill if
you face a loss versus a gain.
00:05:55
So what that means, from the
perspective of tax collectors,
00:05:58
is, first of all, when I'm
forecasting revenue, I need to
00:06:02
forecast, you know, the amount
of tax avoidance activities
00:06:06
that'll happen, and that will be
a function of gain-loss status.
00:06:09
If I'm thinking— thinking where
to aim my, you know— my
00:06:16
enforcement activities— who I'm
trying to audit, things like
00:06:18
that, this suggests you
might want to aim at people
00:06:22
facing losses a little more. And
by the way, I kind of suspect
00:06:24
they're already doing that,
although I don't know for sure.
00:06:26
- Right. - And, yeah, I mean, that's,
like, the largest bit for kind of
00:06:32
tax enforcement. At the higher
level, when you're thinking
00:06:34
about how you want to design the
system, you could design the
00:06:36
system to have more or less
people facing a gain or a loss
00:06:41
on Tax Day, and that's something
that's within our control
00:06:44
based on how we set up,
00:06:45
like, withholding rules
and things like that.
00:06:47
But you would think that it also
potentially has an impact in
00:06:50
terms of the person who's filing
the taxes, on how they think
00:06:54
about things like deductions,
and, you know, ways that they
00:06:58
look to try and make sure that
they have more deductions, so
00:07:01
they're facing a smaller loss.
And I think you even touch on in
00:07:05
the paper that in many cases, we
focus more on how we look at the
00:07:10
losses than maybe we focus on
how we look at the gains
00:07:14
on the other side.
00:07:15
I think that's right. Yeah, so
it definitely— or
00:07:19
my understanding of what's going on is
absolutely that people are
00:07:22
changing kind of the degree of
attention and effort they put in
00:07:24
to, say, pursuing deductions or
maybe pursuing evasion, although
00:07:27
I don't see that directly. - Right.
- Things like that. Yeah,
00:07:32
and so I think that is moving
around. I mean, in some cases
00:07:34
that's desirable, in some cases
it's not, right? So taxes, we
00:07:38
basically have two reasons for
taxing things. One is because we
00:07:41
need money, and we view it as a
shame that we're messing up your
00:07:44
decisions by taxing you to get
that money, in which case we
00:07:48
really don't want you to respond
to the tax. In that case, it's
00:07:51
really convenient if you're
viewing it from, say, a gain
00:07:53
frame, and you're not going to
be as responsive. In other
00:07:56
cases, we really want you to
react to taxes, like when we put
00:07:59
out a soda tax. We're trying to
dissuade people from drinking
00:08:02
soda by making it more
expensive. The whole point of
00:08:05
doing it is to get behavioral
response. And in those kind of
00:08:08
cases, if you could make things
loss framed rather than gain
00:08:10
framed, that would crank up the
behavioral response and be
00:08:13
useful. So that's kind of a way
to riff off of this kind of
00:08:16
observation.
00:08:17
Part of this research, also, you
took a look at how this type of
00:08:21
mindset can impact business
owners, and specifically small
00:08:25
business owners as well.
- Yeah. I mean,
00:08:27
so the the relevant pieces for
thinking about business owners
00:08:31
here are, you know, first, they
have lots of opportunities for
00:08:36
either legal evasion or illegal—
sorry, legal avoidance or
00:08:40
illegal evasion. You know,
relative to say, you know, a lot
00:08:45
of individual filers who say,
just have salary income.
00:08:49
Business owners can get away
with a lot more. Now, why do I
00:08:51
say that? Well, the biggest
determinant of tax evasion is
00:08:56
just whether your income is
matched or unmatched. What do I
00:08:59
mean by that? When the
University of Pennsylvania pays
00:09:02
me my salary, they also tell the
IRS what they paid me. It's
00:09:06
matched, in that sense. Two
parties said exactly what it is,
00:09:09
and if I submit a number that's
different than what Penn said,
00:09:12
they look at my return
immediately. So I have no
00:09:15
opportunity to successfully
evade my salary. - Right.
00:09:19
If I'm running, you know, a sandwich
stand, there's no third party
00:09:23
saying how many sandwiches I
sold— I sold. So as a result, if
00:09:28
the IRS wants to dispute, you
know, what I'm doing or what I'm
00:09:32
claiming my income was, they
have to show up and audit me.
00:09:35
And even if an auditor comes,
it's kind of hard to say
00:09:37
exactly, you know, what happened.
It's a lot of work to
00:09:39
successfully audit people. As a
result, businesses have more
00:09:42
opportunity, potentially, to
evade or do gray area stuff or
00:09:46
legally avoid. And so if you look
at the just total tax gap, which
00:09:50
is the difference between the
total amount of money the IRS
00:09:53
thinks they're supposed to get
and what they actually get,
00:09:56
nationwide, this is like 15%.
We're kind of missing 15% Of
00:10:00
the money we think we should
get, which is pretty good as far
00:10:02
as countries go on tax
enforcement. But for individual
00:10:05
income, it's like— or individual
non-business income, it's like
00:10:09
5% which is really good because
there's so little you can get
00:10:12
away with. For business income,
it's like 40%, right? So there's
00:10:16
just a lot more money missing,
because it's harder to get it,
00:10:19
you know? And so in those cases,
there's a lot more of this
00:10:23
discretionary thing where you
can go in kind of small units
00:10:26
at a time and say, "Do I want to
report this income, or do I want
00:10:29
to legally deduct this business
expense?" Or do all these kind of
00:10:32
discretionary things. And it's
much less of a case where
00:10:36
someone just sends you a thing
and says your— "Your wage was
00:10:38
$100,000, so report that." It's
just incredibly easy, and it's
00:10:42
more of a case where you're
constructing this laboriously
00:10:44
over hours and hours and
deciding at what point you say,
00:10:47
"Oh, this is good enough," and
send things into the IRS.
00:10:49
I guess, to a degree, then,
00:10:51
the— the process of
this overthinking that we have
00:10:55
around taxes does benefit the
IRS in terms of the collection,
00:11:00
and to a degree, holding on to
the money for the period of time
00:11:03
that they do, and the benefit
that they can— that they can
00:11:06
find, at least
in a short period.
00:11:07
There's a few ways in
which that's true or not true.
00:11:10
It's mostly true. But the— you
know, for— the fact that people
00:11:14
are thinking about what
opportunities to pursue, and
00:11:17
then eventually saying, "Oh, this
is more effort than it's worth."
00:11:19
- Yeah. - That is in some ways
helpful, because it results in
00:11:23
people not claiming benefits
they are due. You know, if we
00:11:27
can get that from like, you
know, "the right people", then,
00:11:31
you know. So for example, if you
can use this to get a little bit
00:11:34
of extra income from
comparatively wealthy filers,
00:11:37
that's generally viewed as kind
of desirable. - Right. - On the
00:11:39
other hand, there's a lot of
credits and deductions, where
00:11:42
the whole reason we set them up
is we really want to transfer
00:11:44
money to someone. Like the Earned
Income Tax Credit, which is our
00:11:47
main kind of anti-poverty
program. About 17% of people who
00:11:51
are eligible for it don't claim
it. And we think that's largely
00:11:56
because it's so complicated to
deal with that we've
00:11:58
successfully dissuaded people in
that process. So you know, in
00:12:01
cases where we can save some
money from whatever "the right
00:12:05
people" means, the right people,
it's a kind of good. In cases where
00:12:08
this keeps credits out of
people's hands, where we really
00:12:10
want them to take the credit,
that's very bad. Regarding the
00:12:13
timing of it, there's another
element that's kind of favorable
00:12:16
to the IRS that's not
specifically about prospect
00:12:18
theory, but that interacts with
it. And that's, you know, in our
00:12:22
current regime, most people are
over-withheld. So about 75% of
00:12:25
people get paid money back by
the IRS at the end of the tax
00:12:28
year. - Yeah.
00:12:29
And, you know, for
the people who are doing that,
00:12:32
that's kind of a bad deal in the
sense of, what does it mean? It
00:12:35
means you were giving the IRS
money throughout the year, and
00:12:37
then eventually they give it
back to you, the exact same
00:12:40
amount. Normally, when you give
people money and they give it
00:12:42
back to you later, they give you
interest also. But not so here,
00:12:45
right? So this is an interest-
free loan that the government is
00:12:48
getting from a lot of people,
some of whom are low income, low
00:12:51
income and high income. Across
the board, we have lots of
00:12:54
people loaning money to the
government. And, you know, if—
00:12:58
general advice I have for people
is if you can avoid doing that,
00:13:00
you should probably avoid doing
that. Although very precisely
00:13:03
targeting your withholdings is
kind of a pain, so you got to
00:13:06
decide how much of a— how to
balance these things. So, you
00:13:10
know, this interacts with our
discussion of loss aversion in
00:13:13
the sense that beyond generating
some interest-free loan money
00:13:18
for the government, this
phenomenon of over withholding
00:13:20
is also making people less
motivated than they would be
00:13:22
otherwise to avoid and evade
taxes. So it has like a double
00:13:27
whammy of being kind of
favorable to the government to
00:13:30
have a lot of people in the gain
frame, and the only reason the
00:13:33
government would really want to
intentionally put people in the
00:13:35
loss frame is if they wanted
people to respond to these tax
00:13:38
incentives. So for example, if
they wanted to motivate people
00:13:41
to take up tax credits to do
things like that, right? - Right.
00:13:45
What do you think is, then, your
takeaway from doing this
00:13:48
research, which— it was a couple
years ago, but as you told me,
00:13:51
the mindset and the focus on the
psychology of this has really
00:13:55
picked up and grown in the last
few years as well. - Yeah, yeah.
00:13:57
So you know, there is, like, a
narrow takeaway and a much
00:14:00
broader takeaway. So the narrow
takeaway is kind of
00:14:02
straightforward, in that it
looks like this gain-loss
00:14:05
framing actually matters to
people. It influences what they
00:14:08
do. It influences how much money
the government's going to get.
00:14:11
So we should pay attention to
this stuff, you know. So that's
00:14:13
that's straightforward from
everything we've said so far. The
00:14:15
thing that's a little bit
broader— thinking far beyond
00:14:18
this paper, but this paper is an
example of it, is kind of about
00:14:21
the value of taking psychology
seriously when thinking about
00:14:25
tax policy. And so there's,
like, a field within public
00:14:28
finance called behavioral public
finance that has really taken
00:14:31
off in, say, the last decade,
that's focused on doing this.
00:14:34
And what's— you know, what's the
value proposition of all this?
00:14:37
It's saying, look. The way
economists and economics-related
00:14:42
policy makers think about
setting like the right tax is
00:14:46
generally going to be trading
off two considerations. On the
00:14:49
one hand, we want to have tax
money because the government
00:14:52
needs to build roads and have an
army and do redistribution to
00:14:56
low-income people and do a bunch
of other things, and all those
00:14:58
things to varying degrees we
think are valuable. We can debate
00:15:01
how valuable, but there's some
value in it, and that's the
00:15:02
weight in this hand, right? On
the other hand, getting that tax
00:15:06
money is costly for society. So
it's costly for two reasons. One
00:15:11
is, if I take a tax dollar away
from someone, that hurts that
00:15:14
person. But kind of in some
ways worse than that, when I
00:15:18
impose taxes on society, it
changes what everyone's going to
00:15:21
do. So if I put $100 tax on
apples, no one eats apples
00:15:25
anymore. Everyone starts eating
bananas. And I've made people
00:15:28
worse off, because people who
want apples can't have apples
00:15:30
anymore, you know, because
they're priced in a silly way
00:15:32
now. If I make labor income
really highly taxed, then people
00:15:36
might work a little less and do
something else with their time
00:15:39
rather than work if it's no
longer as profitable, and so on.
00:15:42
And so what we're fundamentally
doing in kind of optimal tax
00:15:46
policy is we're balancing our
need for money to fund the
00:15:49
things that we want to fund and
our desire, like, not to mess up
00:15:52
decisions too badly. - Right.
00:15:54
You know, economists
write really
00:15:56
elaborate models of this to try
to make it look like a very
00:15:59
fancy exercise. And it is. But
at its core, it's just that, and,
00:16:03
like, getting all the details
right. And so when we're
00:16:06
thinking about this component
where it's like trying not to
00:16:09
kind of roughly change what
people do too much, that's
00:16:12
fundamentally about forecasting
what people will choose to do.
00:16:15
We've historically done that by
forecasting them to be really
00:16:18
smart and they do whatever the
maximally smart person would do,
00:16:22
which is an okay approximation
to what people do. But it's not
00:16:24
a perfect approximation, as many
of us will— as should resonate for
00:16:28
many people. And so the real
value proposition here is
00:16:31
saying, "Look, we're getting a
better grip on what
00:16:34
psychological forces are at play
when people respond to taxes,
00:16:38
and by doing that, we're getting
something that allows us to
00:16:40
model what's going to happen
when we impose taxes a bit more
00:16:44
precisely," which fundamentally
affects how you do this trade
00:16:47
off, which fundamentally affects
how you decide what taxes to
00:16:50
use. And so, you know, this
paper is like a very small rock
00:16:54
in like a mountain that's being
built trying to do that kind of
00:16:56
stuff. Just saying, well, these
models of prospect theory which
00:16:59
have loss aversion in them,
they can be one of those
00:17:01
useful models to plug in. But
that, combined with lots of
00:17:04
other studies that are getting
done, is actually showing, hey,
00:17:07
you can really use psychology
00:17:08
productively in this entire
exercise.
00:17:11
Alex, great to have you here. Thank
you so much. - Thank you.
00:17:14
Alex Rees-Jones of the Wharton
School.
00:17:16
- Thank you for listening
00:17:17
to <i>The Ripple Effect</i>. We hope
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00:17:19
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