Wendy De La Rosa, assistant professor of marketing at the Wharton School, explores how people think about tax refunds and why those decisions often don’t align with their financial goals. She explains why many treat refunds as “extra money,” leading to overspending and missed opportunities to save or pay down debt. The conversation also highlights inefficiencies in the tax system, where 20% to 30% of refunded dollars are lost to preparation costs, and shares practical strategies like pre-commitment and automation to improve financial outcomes.
Transcript
The Perception of Tax Refunds
Dan Loney: We are in the middle of tax season. It is a time of the year that also gives us the opportunity to try and better understand some of the behaviors that occur by individuals at this time of the year. When you think about the preparation of your taxes, are you a procrastinator or not? When you're thinking about potential refunds or payments, how do you deal with one or the other? Lots to discuss and a pleasure to be joined by Wendy De La Rosa, an assistant professor of marketing here at the Wharton School who also focuses on consumer financial decision-making.
You know, it is kind of an interesting component of the time of the year, and I guess from a behavioral standpoint, it does give you the opportunity to gain a lot of information and data about how people handle these situations.
Wendy De La Rosa: It does, and what we know from prior work is that people tend to think about tax refunds as windfalls. We don't incorporate it into our regular budgets. We think about this money as sort of special money, which is odd because it's our money coming back to us, right? It's not a gift from anybody. But what that means is that we treat that money differently, and oftentimes what we find is that when people start elaborating and deeply thinking about and anticipating a tax refund, you start to allocate that tax refund multiple times over. You start to tell yourself, “I'm going to use this to pay down debt. I'm going to use this to maybe buy myself something that I've been waiting to buy,” especially in this time period where prices have been rising rapidly over the past couple of years. What ends up happening is that you mentally spend that money three times over. You've allocated across so many buckets that by the time the tax refund comes in, you don't have a real concrete plan.
We talk to a lot of people that have a little bit of regret on how they ended up spending the money. There was this gap between how they planned to do it and how they actually did it.
Loney: Do you see more people focused on, I'll call it a negative in terms of paying down debt, more so than thinking about buying themselves something nice? Like that's the first thing they think about. If they know they have debt, they associate this as an opportunity to pay that down.
De La Rosa: Yeah. We have sort of a bias in which, when we tend to think about our future selves, we tend to think about the perfect version of our future selves.
In the future, you're going to work out more, you're going to save more, you're going to be a better parent, a better spouse, etc. Like we all turn into our individual versions of Beyoncé in the future. Today, when I'm thinking about what I'm going to do for my tax refund in a couple of months, I'm going to think about all of these things that I think my perfect self would do: paying down debt or increasing my savings, and putting some money away for my 529 account. What happens is when the future becomes the present, I've realized that I'm still the same imperfect self as I was yesterday. All of the temptations that come into play come right when the tax refund hits the account. That's the tension that we have.
I'll tell you a little bit of an intervention that we did with a company called Digit a few years ago. We're understanding this tension, this gap between what I intend to do and what I actually do when the time comes, when the rubber hits the road. We send people in this experiment, one of two text messages. In one we said, “You might get a tax refund. If you do, what percentage of it would you like to save early in the tax season in January?” People didn't know if they were going to receive a tax refund or how much, but if they did, they could say 10%, 20%, 50%. And then if Digit noticed a tax refund on the account, they automatically moved that money from their checking account into a savings account. In the other condition, when Digit noticed that there was a tax refund, we texted people and said, “Hey, what percentage of it would you like to save?” They could text any percentage and then Digit would move that money. That timing difference led to almost double the amount of savings rates. So, here's a tool that people can use, of let's pre-commit ourselves early in the tax season and have a very concrete plan about how you're going to save that money or how you're going to pay down debt and then create systems. Digit is just one example where that money then automatically flows in the way that you intend to in January, not in the way that you intend to now.
Procrastination vs. Shock
Loney: Right, because you have the element of procrastination. And I think sometimes procrastinators tend to be people who feel like they're going to owe money when they get their taxes done. That dynamic then probably presents a higher level of pressure on the individual because they're concerned that they've worked hard in the last 12 months, they've done pretty much everything they can, and yet they still owe when the tax return is done.
De La Rosa: Yeah. You know, 85% of tax filers get a tax refund. But you are talking about 15% of the population, particularly, we don't tend to think about this, but gig workers, 1099 workers, so your Lyft drivers, your Uber drivers, their taxes don't get withheld. A lot of them are not just procrastinating, but in shock of how much they have to pay.
I think this year in particular is this unique year in taxes because there's all of this discussion going around that people are going to see a larger than usual tax refund as a result of recent regulation changes, around the order of $1,000. And what we're seeing in the data is that it's bigger, but I want to temper expectations. It's not that people are getting, on average, a tax refund that's high, that's more than $1,000 than what they used to do. The recent regulations have disparate impacts. If you're higher income, you're actually going to be a little bit more well off in terms of your tax refund than if you're lower income.
According to the latest stats by the IRS, tax refunds are about 10% to 11% higher this year than they were last year. What does that translate to? It means like an extra $300 to $400. That's not chump change, right? The average tax refund this year is about $3,600, which if you're earning minimum wage in the United States, that's the equivalent of more than three months of your gross income. These are real dollars that have real consequences. And one of our largest poverty alleviation programs is created through the tax system.
Improving the Tax System
Loney: Are people savvy enough to think about the elements of tax preparation that probably can be considered throughout the course of the year?
De La Rosa: Oh, don't get me started about the inefficiencies of our tax prep program. I think one of the most heartbreaking stats I've come across is … basically like 20% to 30% percent of every dollar that gets sent back through the tax system is being eaten up by tax preparation costs. So, we have this highly inefficient system of filing our taxes, and it doesn't have to be this way. In fact, there are many organizations, including Code for America, that have helped build up easy and free filing tax tools.
But to your second question, why is this so hard? Why is this so hard to plan? One of the reasons why people are getting a higher-than-average tax refund this year, which, again, people treat as a windfall, but you can conceptualize this as a loss, right? This is money that you're not earning any interest on. It's your money. You could have gotten it earlier in the year. It's really because of the inefficiencies in the system. For example, given recent regulations, there were changes to the tax code, but there were no automatic updates to people's withholdings. That's an inefficient system. You're withholding more money, even though you know that the regulations have changed, that the system itself has changed. But there was no automatic update to withholding rates. That's part of the reason why people are getting a higher-than-average refund. If we had a system in place from employers, for example, that really put at the forefront employees' financial well-being and got ahead of this, I think we would help in the planning process much more.
Loney: I'll ask a version of a question that I think every expert is being asked right now. Do you think then that artificial intelligence will play a role in making this better as we move forward?
De La Rosa: Listen, AI is going to touch every aspect of our society, and it's already having a pretty sizable impact in the accounting field. What I will say is that even in the world before AI, we had tools available to us, such as the free filing tool under a different administration, where people could file their taxes for free directly with the IRS. It had an NPS score in the 90s. When was the last time you saw a government tool where people said had an NPS score in the 90s? And that was before AI. While I think AI will be helpful in hopefully making life easier for accountants and making our lives easier as we file our taxes, a lot of the main frictions that we're talking about, we don't need artificial intelligence for. We just need will from our legislative bodies, from consumers to say it doesn't have to be this way. It doesn't have to be this hard. I don't need to get my CPA in order to file my taxes. And we've done it.
Loney: Are there a couple of components, strategies that people should really think about over the course of the year so that they can be better prepared when they get to tax time? So it doesn't become this pressure-filled bomb ready to go off.
De La Rosa: One of the things that is fascinating is that there are very predictable patterns in tax filing rates. It's sort of this inverted view. There's a bunch of people that as soon as they get their W-2, they go and talk to their accountants and file their taxes because they're either liquidity constrained or they're expecting a large refund or, you know what, they just want to get it out of the way. And then there's a big lull that happens basically in the first couple of weeks of March. We're in the lull right now. And then you have the bunch of people who are like, “It's April 14th. Oh man, I better start thinking about my taxes.” Think about who you are and create your environment in a way that makes life easier for you.
As you're thinking about setting up the appointment with your accountant, put a reminder in your phone in January to make that appointment in March. Your accountant's probably going to have more time in early March than mid April. You start to set structures in place of saying, here's my plan. You're making it more concrete.
The second thing I would say is we know that when we try to reach our goals, especially our financial goals, having a buddy, having a partner and vocalizing it really matters, right? Think about talking to your friend and say, “When I get my tax refund, I am going to do X.” Have that accountability with your buddy. Then the third, and this is where technology, and again, it doesn't have to be AI, but just technology, it can be helpful, is create a system in place where you can pre-commit. There are companies and fintech startups that just allow you, when there's a deposit from the IRS, automatically send whatever percentage makes sense for you to either pay down debt, to save, to whatever you want so that you don't have to be in the seat when you're the most tempted to spend to make these decisions.
