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The Uncertainty of Reference Points: Evidence from Tax Refunds
Short Abstract
Each year millions of households receive income tax refunds due to an array of tax credits and over withholding. While the life cycle/permanent income hypothesis (LC/PIH) theory predicts that household spending behavior should not be affected by receipt of the refund, the empirical evidence has shown a sensitivity in consumption related to timing of the refund. This paper offers a possible explanation for the spike in consumption around tax season by reviewing savings choices of tax filers. Using survey data from two tax preparation sites, information was collected on filers planned use of refund as well as the expected refund amount. Filers had the option to open a savings product on site. While less than 40% of filers were able to (or willing) to estimate their refund, the group revealing their expectation is less likely to spend their refund immediately. Moreover, having a tax refund expectation is positively associated with opening a savings product and with previous savings experience. The possibility that a priori refund expectations are related to individuals spending choices has potential implications in policy programs. Providing households with information to establish an exogenous reference point might be a useful mechanism to foster better financial and economic behaviors.