Tax Returns and Loss Aversion

Yet another example of seing silliness from within: it’s now tax return season in Australia. So I am hearing from friends and family that they got this and that in tax returns (often to the sum of several thousand dollars). Last week I do my tax return and since it’s through an application that communicates with the tax office over the internet, it gives me an estimate straight away. I have to pay them about $350.

“Crap!” I think, “I was already planning how to spend that money”. But then the obvious hit me (which it also did a few years ago when I also got a negative tax return): this is just a classic case of loss aversion. To a human, losing $100 is a lot more painful than gaining $100 is pleasurable so just by changing how a scenario is framed you can solicit entirely opposite intuitions. In this case, I had of course already gotten my tax refund of several thousand dollars, just spread over the entire year due to not paying that tax in the first place! It’s those who have the highest tax refunds that are worst off since they have been screwed over by the pay-as-you-go system. The rational response when getting a $5,000 tax return is: “Crap! I could really have used this money over the course of the year”. But the brain is wired differently.

Of course there is some value in having some extra enforced saving through small overpayments during the year with a lump sum cashback at the financial year’s end. But even that is only valuable because of other human foibles: if we didn’t have these cognitive bugs about money we’d be perfectly fine putting away those crumbs ourselves into a savings account to get an even bigger lump sum at year’s end.

Ultimately it seems to me that the tax return is just a case of tax systems taking advantage of loss aversion to reduce the negative feelings towards the tax system. In reality a positive tax return should be viewed with annoyance. It’s also interesting to note that there’s a natural reaction to defend a cognitive bias. For instance I’ve done it in the previous paragraph by appealing to tax returns as an idea of saving. Even though I dismissed this it’s useful to note how our brain may just be confabulating to justify its irrationality. Evolutionary arguments (loss aversion was useful and hence selected for) are I think in the same category. Yes it might have been selected for, but the whole point is that what was selected for was not optimal. The optimal thing would be a mechanism that does a more thorough analysis of each situation to get the best out of it.

Speaking of which, here’s a wonderful recent TED talk. It outlines research into monkeys that suggests they have pretty much the same loss aversion (and risk aversion) as humans. The main difference is that we haven’t yet discovered any methods monkeys might employ in post-hoc rationalisations of how their loss aversion was actually good, even in this particular case where they missed out on more grapes.

Video Link