First, using some of the models of human rationality, analyze these features, common of many income tax codes:
(a) Most of the taxes to be paid are collected by income payers (employers, banks) by withholding an estimation of the tax due by the taxpayer before the net income tax is paid to the taxpayer, instead of paying the taxpayer the gross income and having him or her paying the precise tax due afterwards.
(b) Tax withholding is structured usually in such a way that most citizens get a positive refund or tax rebate once a year.
Second, discuss the welfare consequences of a constitutional rule preventing the government from using withholding taxes.
By using withholding taxes, the government eliminates a “loss”. E.g., the value of two payments of 100 and –20 is lower than the value of 80, according to the asymmetric value function.
Two other points:
The reduction of self-control costs is important here. In fact, it is said that some people ask their employers to withhold them more taxes than it is mandated by the tax code, just to increase their tax rebate.
An argument about limited rationality can also be built, claiming that withholding hide from taxpayers the amount of tax, which they are really paying.
At least two issues are crucial. First, the visibility of paid taxes is reduced. Second, with the withholding system, if tax-payers minds are wired in a way similar to the Kahneman-Tversky asymmetric value function, they would see more value (therefore, lower taxes) under the current arrangement. Furthermore, the taxpayer loses the interest on the excess of the withheld tax.
The effect would probably be ambiguous. If the amount of taxes is kept constant, people would/might be less happy. Furthermore, self-control costs would increase, but the market would provide efficient solutions. One may also think that information asymmetries in the political market would be reduced. As a result, taxes and public expenditures would probably be reduced or other taxes would increase. However, people may overestimate (instead as now, probably underestimate) public expenditure. If that were the case, we would go from too much government to a too small government.
By developing institutions, which would reduce the costs of self-control. For instance, bank accounts with heavy penalties for withdrawing money would probably proliferate. Also firms would increase and adjust the timing of their annual bonuses.
“The principle of cancellation states that losses will be integrated with larger gains where plausible. The best example of this is withholding from paychecks. In the present framework the least aversive type of loss is the reduction of a large gain. This concept seems to have been widely applied by governments. Income taxes would be perceived as much more aversive (in addition to being harder to collect) if the whole tax bill were due in April. The implication for sellers is that every effort should be made to set up a payroll withdrawal payment option. Probably the best way to market dental insurance, for example, would be to sell it as option to group health insurance through employers. If the employee already pays for some share of the health insurance then the extra premium would be framed as an increase in an existing deduction; this is the ultimate arrangement for a seller.” (Thaler, 1985, p. 39 in 1991).
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