By Daniel Hemel
February 14, 2019
IDEAS
Hemel is an assistant professor at the University of Chicago Law School.

Millions of Americans who received tax refunds in previous years could find that they owe money to the federal government this filing season. No doubt that news will come as an unwelcome surprise to individuals and families who had been counting on a refund check, but now find themselves in debt to the IRS. But does it matter, from a policy perspective, how many taxpayers receive money back or owe extra at tax time?

Yes. Although the refund statistics do not tell us how many households benefitted from the Republican-backed tax cuts that went into effect this past year, refunds do matter to the overall health of the tax system. A sharp reduction in the number of taxpayers receiving refunds would likely lead to higher levels of tax evasion and avoidance—and could erode faith in the federal tax laws.

In a nutshell: Refunds matter, though not for the reasons that many taxpayers and some politicians think they do.

The Incredible Shrinking Refund

To understand the recent controversy over refunds, it helps to start with the basics of tax withholding. Every year, the IRS produces tables that employers use to determine how much they should take from each employee’s paycheck and send to the federal government. When employees file their tax returns the following year, they get credit for the amounts that their employers have withheld and remitted on their behalf. “Overwithholding” refers to the situation in which an employer has set aside more money than a wage-earner actually owes, thus entitling the worker to a refund from the IRS when they file their return. “Underwithholding,” as the name implies, is the opposite: an underwithheld worker must pay an additional amount to the IRS at tax time. Overwithholding is much more common than underwithholding. In the typical year, about three-quarters of wage-earners are overwithheld.

In January 2018, the IRS released new withholding tables that accounted for changes to the tax code signed into law by President Trump the previous month. House and Senate Democrats voiced concerns that the new tables might cause employers to underwithhold, thus leaving more taxpayers with debts to the IRS this filing season. In particular, Democratic lawmakers worried that the tax agency was under political pressure from the White House to reduce withholdings so that workers would take home larger paychecks and think that they had received sizable tax cuts in the run-up to the 2018 midterm elections.

Those fears became more acute in July, when the nonpartisan Government Accountability Office published a report forecasting that 21% of wage-earners would owe more than $100 in additional taxes this filing season. That’s an increase of 3 percentage points from the share who would owe more than $100 under the old tax code. Bracing for the possibility that underwithholding would spike, the IRS announced in January that it would waive penalties for taxpayers whose withholdings and other prepayments cover at least 85% of what they owe (the usual threshold is 90%.) Concerns mounted this month when the IRS released statistics showing that the average refund among early filers this season is down $170 from the same period last year.

Senator Kamala Harris, a California Democrat who is seeking her party’s 2020 presidential nomination, seized upon the IRS’ early refund statistics as evidence that “the President’s tax cut” was really “a middle-class tax hike to line the pockets of already wealthy corporations and the one percent.” Commentators criticized Harris for conflating tax liabilities with tax refunds. An individual’s tax liability is the total amount that she owes the IRS in any given year, while a refund is the amount that the taxpayer receives back from the IRS at tax time if their withholdings and other pre-payments exceed her tax liability. “It’s your total tax liability, not your refund,” declared the headline of one Forbes column.

Why Refunds Matter

Harris’ critics are correct that the IRS’ refund statistics don’t tell us how many households are benefitting from the new tax law. But the senator’s emphasis on the refund numbers is not entirely misplaced. Underwitholding is a real problem for our tax system—and one that the IRS’ new tables may have exacerbated.

For one thing, underwithholding affects tax compliance. A number of studies in the United States and elsewhere have demonstrated that individuals are more likely to shelter income or look for other ways to reduce their tax liability if they owe money at tax time than if they are due a refund. Explanations for this phenomenon build upon the work of Nobel laureate Daniel Kahneman and his late longtime collaborator Amos Tversky, who found that individuals will go to greater lengths to avoid a loss than to obtain an equivalent gain. Consistent with Kahneman and Tversky’s theory, underwithheld taxpayers—who view themselves in a loss position at tax time—seem to be more motivated to evade and avoid than overwithheld taxpayers, who see themselves as being in a position of gain.

A recent article by Alex Rees-Jones of the University of Pennsylvania and the National Bureau of Economic Research uses more than a decade of IRS data to estimate the magnitude of this phenomenon. According to Rees-Jones, underwithheld taxpayers manage to reduce their tax liability through evasion and avoidance by an average of $34 relative to overwithheld taxpayers. If that figure is correct, then a 3 percentage point rise in underwithholding would cost the IRS well over $100 million a year in revenue.

That $100 million figure is a drop in the bucket for the federal government, which takes in more than $3 trillion each year. But public opinion surveys and qualitative sociological research suggest that refunds also affect Americans’ overall attitude toward the tax system. Higher rates of underwithholding—which would mean that fewer Americans receive refunds—will likely to lead more negative attitudes toward taxation, which in turn will make it harder for the federal government to generate revenues in the future.

Underwithholding also places strains on the IRS. It means that the agency—whose workforce has shrunk by about a third from its peak—must devote more of its limited resources to tracking down taxpayers who owe more but haven’t paid, as well as to negotiating installment plans with taxpayers who lack the cash to satisfy their obligations. Those efforts divert personnel from other important tasks, such as auditing returns and assisting taxpayers in the filing process, with follow-on consequences for revenue and for public confidence.

While the social costs of underwithholding are significant, excessive overwithholding is potentially problematic too. Overwithholding works like a savings account that accrues zero interest — no better than stuffing cash under a mattress. Some taxpayers nonetheless find that overwithholding is a convenient, if not entirely economical, way to save more each year, and they deposit their refund checks into retirement accounts each spring. But if withholding takes too large a chunk out of workers’ paychecks, it can have harmful effects — causing them to rack up credit card debt or payday loans in order to meet basic needs. For some cash-strapped households, overwithholding may be as worrisome as its opposite.

All this suggests that the optimal system may be one in which the vast majority of taxpayers receive relatively small refunds, but very few owe extra at tax time. With two more months until the April 15 filing deadline, it’s still too early in the season to say whether the IRS’ new withholding tables have missed this mark. In the meantime, taxpayers should continue to hope for a refund when they file—but not, perhaps, one that’s too large.

Contact us at editors@time.com.

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