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Dan ArielyBack to OpinionDan Ariely

Does the U.S. tax system encourage promiscuous spending?

Tax day, April 18, looms for many Americans. Photo: Flickr/427

Tax day, April 18, will soon be upon us, so it’s a perfect time to contemplate a few aspects of our tax system.

In the past I’ve written about how I used to think that tax day was a wonderful day of civic engagement – a day to think about how much we make and contribute, the taxes we pay and the services we get in return. Of course, over the years, as my tax returns became more complex, this task became one that was less about civic engagement and thoughtfulness and more about annoyance and frustration. … But that conversation is for another time.

Today, I want to discuss the fact that the U.S. tax system makes it very difficult for us to understand how much money we make and how this may actually lead us to spend more money than we really have. Think about it for a moment: Do you know your net monthly income? I suspect you don’t, and I think that the tax system is the reason for this.

In many other countries, the tax code does not allow for the same level of deductions as our own, and so, for most people, the whole amount of taxes is automatically deducted from their paycheck – and that’s it. Now, in this situation, when you ask people how much they earn (and yes, in other countries people do actually ask each other what they make), they will usually tell you their net monthly income (i.e., the amount of money that they actually take home at the end of each month). How do they know? Well, it’s the number that’s prominently featured on their paystub.

Contrast this to the U.S. In this country, most of us know the gross amount that we make every year, but are less sure about what our net income is. It’s actually very complex because we get our salary, some of which the employer withholds, and we have no idea what we’ll get back when tax day comes around. We can get back some money, depending on our expenses and deductibles, trends in our stock market portfolio and expenses, health care, etc. And of course we figure this out around April 15 (if not later) of the following year!

And what are the consequences of knowing our gross yearly income and not much else? I think it causes us to feel richer than we really are and spend accordingly. Why would this be the case? There’s a phenomenon called the “illusion of money,” which is the idea that we typically pay attention to nominal amounts of money rather than real amounts. For example, the illusion of money means that if inflation was 8 percent and you got a 10 percent raise, you would feel better than if there was no inflation and you got a 3 to 4 percent raise. The basic idea is that we pay attention to the nominal amount rather than the purchasing power, and don’t realize what our money is really worth.

In terms of our tax code, this suggests that in the U.S. we focus on our gross yearly income, which often makes us feel richer than we really are, and encourages us to spend more money. If this is right, it means that changing the structure of deductions could be one way to help people understand how much money they actually have and how they can save more.

More of Dan Ariely’s writing can be found at Predictably Irrational.


  • Anonymous

    i hope ‘they’ are listening.

  • Banicki

    First we need to fix our economic system.

    There is much debate about whether the tax rates should be kept low or raised to the rates prior to the George W. Bush years. This
    is the wrong debate. Instead we should be deliberating whether we need
    to reform our economic system. If our markets were more free we would
    have a wider distribution of income and the result would be more tax
    revenue to the government with lower rates.

    The republicans speak
    with pride how the free market system is the best economic model for
    increasing the living standards of the nation and the citizens of the
    country. They resolutely  proclaim
    that government needs to cut back on regulation and allow the free
    market to work. I personally find this hard to argue against.

    However, what I do not
    understand is why most free market advocates are not up in arms  over
    our markets and industries being taken over and controlled by a small
    group of firms in many of our industries. The founder of the concept of free markets said: