Income Tax Withholding and Reference-Dependence: Experimental Evidence on the Role of Salience

Abstract

It is recognised in the existing economic literature that income tax withholding arrangements, near-universally adopted in higher-income economies, reduce the salience (or visibility) of tax payments, compared with self-reporting arrangements in which individuals file a tax return directly. However, traditional economic models, and existing reference-dependent preference models, fail to account for this effect. This paper exploits an individual’s labour choice decision to model this phenomenon via reference-dependent preferences, varying the reference point across the respective systems. Withholding is framed as a gain in net income, whereas self-reporting is framed as a loss against gross income. A survey experiment, adapting a design by Abeler et al. (Am Econ Rev, 101(2): 470-492, 2011), is then utilised, in which subjects choose between rewards framed as above, to examine the existence of this effect. For the same net reward, subjects state a higher mean effort under self-reporting, and effort appears to cluster according to the predicted use of reference-dependent preferences. Thus salience appears to play a significant role in labour responses to tax remittance methods.