Tax Overwithholding as a Response To Uncertainty

Abstract

This article analyzes a basic timing problem faced by taxpayers—they must choose their levels of withholding and/or estimated tax payments before knowing exactly what their incomes and deductibles will be. Thus, the laws on withholding impose a compliance cost on taxpayers because they must pay a government-imposed penalty when they underwithhold and they must, in essence, give the government an interest-free loan when they overwithhold. The model in this article shows that when the penalty for underwithholding exceeds the opportunity cost of overwithholding, it is optimal for taxpayers to overwithhold more often than they underwithhold. Furthermore, this model is shown to substantially explam the observed withholding patterns for the U.S. individual income tax.