Mental Accounting: Why You Blow Your Tax Refund but Not Your Raise
The first (and last) time I went to Las Vegas, I discovered that gambling is not for me. I was in Sin City for a cousin's wedding, and my generous parents were bankrolling my minimal gambling. The first day, they had given my sister and me about $50 each to spend on the slot machines, and I had sidled up to an electronic poker game full of excitement.
My first or second round won me about $100. I was tempted to take the money and run, but since everyone else in my family was glued to a poker machine, I decided to see if I could keep the winning streak going. Less than 20 minutes later, after seeing my winnings balloon to $200, I then lost everything, and was staring at the machine in stark, unimaginable horror. (My thought processes were: "So you're saying I put money in, press a few buttons, no fun comes out, and I'm down 50 bucks? What the hell?")
My sister comforted me by saying, "Hey, at least you didn't lose any real money."
At the time, I thought this was a very odd statement. How was my dad's $50 not real money? No, it wasn't technically my money, but that didn't make it any less spendable. For that matter, how was the $200 I should have run with not real? (See also: Party Like It's 19.99: The Psychology of Pricing)
Understanding Mental Accounting
This was an important lesson for me on the weirdness that is mental accounting. Economist Richard Thaler came up with this term, and it refers to the fact that we value money in different ways depending on where it comes from, what we plan to spend it on, and where we keep it.
For many people, gambling wins don't count as "real" money, because it's not something you had to work to earn. (I don't personally feel that way, but I seem to lack the gambling gene. Not to worry — I do have plenty of other mental accounting issues.) This is why you can bring $100 to Las Vegas to gamble, get up to $10,000 in winnings that you lose in a single hand, and still feel as though you've only lost $100 total.
Of course, mental accounting is not just about gambling. Thaler came up with the quintessential test of mental accounting:
Imagine that you have decided to see a movie and have paid the admission price of $10 per ticket. As you enter the theater, you discover that you have lost the ticket. The seat was not marked, and the ticket cannot be recovered. Would you pay $10 for another ticket?
Most people would answer no to this particular conundrum. But change a single factor, however, and the answer changes:
Imagine that you have decided to see a movie where admission is $10 per ticket. As you enter the theater, you discover that you have lost a $10 bill. Would you still pay $10 for a ticket to the movie?
Oddly enough, most people answer yes to the second question. If you look at these two questions rationally, it's abundantly clear that you're out $20 either way. But in the second scenario, the $10 bill you lost was not already earmarked for your movie. Your accounting of that $10 means it's subtracted from some other "fund," whereas your movie will still cost $10, rather than the difficult-to-accept $20.
What it comes down to is the fact that a dollar is not a dollar to us irrational spenders. Traditional economics holds that money is fungible — that is, that money retains its value no matter where it came from. That would suggest that gambling winnings, salary, tax refunds, and found money would all be spent similarly. According to Gary Belsky and Thomas Gilovich, authors of "Why Smart People Make Big Money Mistakes and How to Correct Them," theoretically, "every financial decision should result from a rational calculation of its effect on our overall wealth." But anyone who has ever found an unexpected twenty in a pair of jeans and had lunch on it knows that this is not the case.
Tax Refunds vs. Raises
Every spring, we see the phenomenon of mental accounting in action with the way people spend their tax refunds.
Wise Bread readers are all certainly familiar with the idea that getting a huge refund each year is a waste of money. Letting the government borrow your money interest-free for a year is not the most economically advantageous use of your funds.
However, many individuals who are well aware of the "folly" of lending Uncle Sam free money will still plan on structuring their withholding so as to get a large refund. The reason? It makes the mental accounting easier. Dealing with a large lump sum in April is a heck of a lot easier than trying to keep track of a little bit of money from every paycheck.
Then, of course, there's what that large lump sum is used for. People will often plan on spending their tax refund on a vacation, a big-screen TV, or another indulgence, forgetting the fact that they could have easily saved up for that indulgence with the small amount from each paycheck. They also treat this money as different from their salary, even though that's exactly what it is.
According to Shankar Vendantam of The Washington Post,
Ohio State University psychologist Hal Arkes once found that mental accounting influences how people deal with sudden gains, such as lottery winnings. The same phenomenon influences millions of Americans at tax time, when they gleefully look forward to refund checks from the government — even though refunds are really their own money being returned to them, minus interest. In terms of mental accounting, lottery winnings and refunds are invariably counted in the category of 'free money' — which is why people spend such dough not on health care, utilities, and eliminating credit card debt but on discretionary items such as vacations or new patios.
Compare this attitude with how workers plan to use raises. Knowing that you have an extra $2,000 coming this year because of your 4% raise generally means you will start planning extra contributions to retirement, debt-payoff, or charity, or finding other (mostly) responsible ways to spend the extra money.
But if you were to get a $2,000 refund check come tax time, your view of the exact same amount of money changes. That's no longer money that you need to spend responsibly — it's yours to blow.
Responsibly Channeling Mental Accounting
The problem with mental accounting is often the same one you encounter with traditional accounting — forgetting the fungibility of money. For example, you might find yourself banging your head against the wall at work as your boss tells you that you're free to take an unnecessary business trip since there's plenty of money in the travel account, but that you cannot buy an absolutely essential laptop because the computer budget is empty.
With mental accounting, you might find yourself scrambling to pay for necessary car repairs even though you just came back from a lavish vacation. If you had held back a few hundred dollars from your vacation account, you could easily pay for your car repair. But since you accounted for those amounts separately, you felt free to spend every penny from your vacation account while leaving yourself high and dry should something come up with your car.
One way to deal with this issue is to make your mental accounting more tangible. Dave Ramsey famously promotes the cash envelope system, which forces you to put money aside for various spending categories. This in turn makes you keep more careful track of what you spend.
For instance, with the envelope system, the original movie ticket question would be moot. The $10 you lost in the second scenario would have come from your entertainment budget (since that's all you'd be carrying in your cash envelope), so you would have to acknowledge the fact that you're paying $20 for the film no matter what.
In addition, having separate savings accounts for various long-term spending categories can help to ensure you do not accidentally spend your home repair budget on a new television.
Doing these things can give your brain a break from the majority of your mental accounting — which would theoretically make it easier for you to make (more) rational decisions when you have to use mental accounting.
Then, perhaps, you'll be in a better position to realize that if you're up by $200 in Las Vegas, you should quit playing.