To begin, prospect theory explores the fact that people prefer avoiding losses to acquiring gains. This is because the gain function is convex and the loss function is concave. Losses subtract from utility more than gains add to utility. These ideas were first introduced in Kahneman and Tversky (1979).

On the other hand, mental accounting explores how people group and categorize gains and losses. Individuals will tend to group gains and losses together to mitigate the impact of the loss on overall welfare. Concepts and implications of mental accounting are explored in Thaler (1999). Finally, mental accounting and framing are similar because the way that a person frames an activity will allow it to be mentally accounted for in a particular way. For example, pretend someone wants an excuse so go shopping. Which is a more convincing argument to the spouse: “I saved 15% when I bought this” or “I avoided a 15% fee when I bought this”? “Savings” is obviously the preferred method of characterization. It is clear that how individuals frame and account for gains and losses is important to perceived additions to and subtractions from overall utility or welfare.

As it is today, income taxes are paid by employees each pay period. Employers calculate, based on tax forms provided by the employee, how much income tax should be withheld from each paycheck before checks are written. On April 15 each individual is responsible for preparing an individual income tax return for the previous calendar year. If the amount owed is greater than the amount that has already been deducted from the employees’ paychecks the taxpayer must write a check to the IRS for the difference; if the amount owed is less than the amount that has already been deducted from the employees’ paychecks the IRS owes that individual the difference.

In the context of mental accounting, behavioral economics says that people will wish to combine losses with gains in order to diminish their negative impact. As this is the case we can look at each pay period as a mental time frame. Said differently, it is easier for an employee to accept a $525 gain with a $175 loss ($700 weekly paycheck minus 25% marginal tax rate of $175) than to accept a onetime yearly loss of $8,750 ($175 weekly tax multiplied by 50 weeks per year).

Further, we know from prospect theory that losses will hurt less over time. I submit that when income taxes are withdrawn before paychecks are written the loss can become virtually eliminated. People tend to view their paycheck as, “I make $525 per week.” Few people view their paycheck as, “I make $700 per week and after an income tax withholding of $175 I am left with $525.” This is especially true as time goes on. Everyone that looks at their first paycheck is furious at how much taxes have come out of it; after a month or two, no one gives it a second thought.

By paying a portion of income taxes each pay period taxpayers are allowed to integrate gains (the paycheck) with losses (the tax withheld). Further, the fact that taxes are taken out before employees receive their pay allows employees to become acclimated to taxes to the point they no longer perceive they are even paying them. It is, therefore, my contention that the absence of allowing taxpayers to mentally offset the pain of paying the tax with the gain of receiving a paycheck and withholding income taxes from issued paychecks would have a large negative impact on overall utility. It is because taxes are withheld and gains and losses integrated that current marginal tax rates can be deemed “socially acceptable.”

An interesting topic for more research would be to empirically measure the indifference between the way taxes are paid and the “acceptable” average income tax rate i.e., taxpayers might be indifferent between the following.

Payment Method                                                          Socially Acceptable Tax Rate
Tax is withheld from paycheck                                               25%
each pay period.

Tax is paid each pay period                                                     22%
but not withheld from paycheck.

All income tax is due April 15                                                   15%
payable by check.

All income tax is due April 15                                                   9%
payable in cash at local tax office.

Kahneman D. and Tversky A., (1979), Prospect Theory: An Anlysis of Decision Under Risk, Econometrica, March, 48(2), 263-291.

Jackson S., Shoemaker P., Barrick J., Burton G., (2005), Taxpayers’ Prepayment Positions and Tax Return Preparation Fees, Contemporary Accounting Research/Recherche Comptable Contemporaine, Summer, 22(2), 409-447.

Jackson S. and Hatfield R., (2005), A Note on the Relation between Frames, Perceptions, and Taxpayer Behavior, Contemporary Accounting Research/Recherche Comptable Contemporaine, Spring, 22(1), 145-164.

Thaler R., (1999), Mental Accounting Matters, Journal of Behavioral Decision Making, 12, 183-206.