Reexamining Income Tax Overwithholding as a Response to Uncertainty

Abstract

This article reexamines whether significant income tax overwithholding in the United States can be explained as rational risk-neutral taxpayers trying to avoid underwithholding penalties when faced with uncertain tax liabilities. Starting with the important model developed by Highfill, Thorson, and Weber, we add interest accumulated on underwithheld income, consistent boundary conditions, and nominal penalty and opportunity costs. We then incorporate a relevant tax rule into the model. Finally, we consider alternative distributions of taxable income. Under these modifications, penalty avoidance generates refund rates only a quarter to a half of those observed in the United States in the 1980s and the 2000s. This suggests that penalty avoidance in a risk-neutral framework is not sufficient to explain the puzzling overwithholding behavior of US taxpayers.