Tax Overwithholding as a Response to Uncertainty.” Public Finance Review

This article analyzes a basic timing problem faced by taxpayers—they must choosetheir levels of withholding and/or estimated tax payments before knowing exactlyw attheir 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. U.S. taxpayers tend to overwithhold their income taxes. In recent years, the proportion of all taxpayers who overwithhold sufficiently to receive refunds has averaged nearly 75%. There is no consensus, however, on why taxpayers do so. This article briefly reviews the evidence on overwithholding in the United States and surveys the reasons suggested in the literature for this phenomenon. The major goal of this article is to provide a theoretical explanation for overwithholding based on the traditional economic assumption of individual rational self-interest. The article will then show that this model substantially explains the observed withholding patterns for the U.S. individual income tax. The uncertainties facing taxpayers in choosing their withholding and/or estimated tax payments are well known. This article focuses on one consequence of this uncertainty, the &dquo;timing problem&dquo; face