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Should the Average Tax Rate Be Marginalized?

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  • Naomi E. Feldman
  • Peter Katuscak

Abstract

Economic theory assumes that taxpayers use their true marginal tax rate (MTR) to guide their economic decisions. However, complexity of the personal income tax system implies that taxpayers may incorrectly perceive true marginal prices and incentives. We first develop an updating model that formalizes this proposition. A prediction of this model is that an unexpected innovation in the previous year's average tax rate (ATR) influences the perception of the MTR in the current year, even though the MTR is not in fact changing between the two years. This model generalizes the \schmeduling" hypothesis of Liebman and Zeckhauser (2004), who suggest that taxpayers use the ATR in place of the MTR in making their decisions. Then, assuming that taxpayers react to their perceived after-tax price as economic theory would suggest, we test this prediction empirically by examining whether household labor income responds to predictable (but not necessarily predicted) variation in the previous year's ATR due to eligibility for the Child Tax Credit, which depends on the exact timing of a child's 17th birthday. We find that household labor income decreases in response to losing eligibility for the Child Tax Credit. This finding is inconsistent with the rational taxpayer hypothesis, but consistent with the schmeduling hypothesis. Our robustness tests do not provide any consistent evidence that this result is entirely driven by an omitted variable bias due to a direct timing of birth effect. We also discuss the welfare consequences of schmeduling.

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Bibliographic Info

Paper provided by The Center for Economic Research and Graduate Education - Economic Institute, Prague in its series CERGE-EI Working Papers with number wp304.

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Date of creation: Sep 2006
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Handle: RePEc:cer:papers:wp304

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Keywords: Tax; labor supply; average tax.;

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References

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  1. Nada Eissa, 1995. "Taxation and Labor Supply of Married Women: The Tax Reform Act of 1986 as a Natural Experiment," NBER Working Papers 5023, National Bureau of Economic Research, Inc.
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Cited by:
  1. Blumkin, Tomer & Ruffle, Bradley & Ganun, Yosef, 2010. "Are Income and Consumption Taxes Ever Really Equivalent? Evidence from a Real-Effort Experiment with Real Goods," IZA Discussion Papers 5145, Institute for the Study of Labor (IZA).
  2. Looney, Adam & Singhal, Monica, 2006. "The Effect of Anticipated Tax Changes on Intertemporal Labor Supply and the Realization of Taxable Income," Working Paper Series rwp06-031, Harvard University, John F. Kennedy School of Government.
  3. Koichiro Ito, 2012. "Do Consumers Respond to Marginal or Average Price? Evidence from Nonlinear Electricity Pricing," NBER Working Papers 18533, National Bureau of Economic Research, Inc.
  4. Raj Chetty & Adam Looney & Kory Kroft, 2007. "Salience and Taxation: Theory and Evidence," NBER Working Papers 13330, National Bureau of Economic Research, Inc.
  5. Raj Chetty, 2009. "The Simple Economics of Salience and Taxation," NBER Working Papers 15246, National Bureau of Economic Research, Inc.
  6. Aviva Aron-Dine & Liran Einav & Amy Finkelstein & Mark Cullen, 2012. "Moral hazard in health insurance: How important is forward looking behavior?," Discussion Papers 11-007, Stanford Institute for Economic Policy Research.
  7. Aviva Aron-Dine & Liran Einav & Amy Finkelstein & Mark R. Cullen, 2012. "Moral Hazard in Health Insurance: How Important Is Forward Looking Behavior?," NBER Working Papers 17802, National Bureau of Economic Research, Inc.
  8. Jane K. Dokko, 2008. "The effect of taxation on lifecycle labor supply: results from a quasi-experiment," Finance and Economics Discussion Series 2008-24, Board of Governors of the Federal Reserve System (U.S.).

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