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