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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.