Mental Accounting: Why You Blow Your Tax Refund but Not Your Raise

by Emily Guy Birken on 12 March 2013 5 comments

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.

Tagged: Taxes
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Guest's picture
M

Never been to Sin City so I can't comment on gambling. But your post still gives me lots to think about. Here in Canada we have something called an RRSP (sort of like a IRA). Most people don't consider that their big, fat refund at tax time is just the government giving you back your pre-paid taxes. They blow it on discretionaries instead. If they used this money to eliminate their mortgage they would be investing at about 3% TAX FREE (since we don't pay taxes on the sale of the primary home). This could could also eliminate the irrational worry about the future. But like you said, most folks don't view a tax refund this way.

Guest's picture
Jose

MY tax refund is going to be used 100% towards paying off a debt, all of it State and Federal. Pay raises get treated the same except I use a portion of it to increase my 401k withholding. 10 Years ago I probably would have done what you have described but I hope that time and age have taught me better!

Guest's picture

Never been to Sin City so I can't comment on gambling. But your post still gives me lots to think about.!!

Guest's picture
Guest

I didn't think I'd have a chance to brag about this anywhere. I should have guessed wise bread would have been the place. This year we had a sizable refund (and no its not because we don't take the correct deductions).

When we received our refund that money got split into 3 savings accounts (we don't have any debts other than mortgages). Most went into our emergency fund which is probably a bit over 12 months now, a nearly equal amount went to our car replacement account, and finally we got to add and extra $1,000 to our vacation account.

I still feel like I want to but something for the family, but after years of being very clear with needs and wants, the wants really do diminish. Its not that I can't splurge, we can and with more money and less guilt, I just don't have the desire for "things".

Guest's picture

I think we are all guilty of mental accounting from time to time - I'll be the first one to admit it for myself. Being aware of it is already a step to the right direction, but learning to avoid it where it really matters is what makes all the difference. I believe two things can really help: learning to to be careful in terms of absolute dollar amounts - rather than percentages or "doubling" or "halving" your cost/money - and learning to systematically live beneath your means.

Thinking in absolute dollars helps you to put things in perspective, no matter what decision: whether you set your mental "pain" threshold is $10, $100, or $1000, you will always think carefully when spending that amount or anything above. And when it's less, then you have your own permission not to sweat it (unless you really want to). This helps you to pay attention when you need to, but you still have enough flexibility to make your decisions as you need to.

Living beneath your means is even more important a way to avoid the traps of mental accounting. When you always pay yourself first and sock away 10% of your income - or 15% or even 20% if you can - and invest it, you can be much more flexible with what you do with the rest. If you can develop this habit, you also tend to become more prone to find further opportunities to save more, and be less probably to blow your money on the whim of the day.