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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.

Suggested Citation

  • Naomi E. Feldman & Peter Katuscak, 2006. "Should the Average Tax Rate Be Marginalized?," CERGE-EI Working Papers wp304, The Center for Economic Research and Graduate Education - Economics Institute, Prague.
  • Handle: RePEc:cer:papers:wp304
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    File URL: http://www.cerge-ei.cz/pdf/wp/Wp304.pdf
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    References listed on IDEAS

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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.
    2. J. A. Mirrlees, 1971. "An Exploration in the Theory of Optimum Income Taxation," Review of Economic Studies, Oxford University Press, vol. 38(2), pages 175-208.
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    Cited by:

    1. Adam Looney & Monica Singhal, 2005. "The effect of anticipated tax changes on intertemporal labor supply and the realization of taxable income," Finance and Economics Discussion Series 2005-44, Board of Governors of the Federal Reserve System (U.S.).
    2. Raj Chetty & Adam Looney & Kory Kroft, 2009. "Salience and Taxation: Theory and Evidence," American Economic Review, American Economic Association, vol. 99(4), pages 1145-1177, September.
    3. Blumkin, Tomer & Ruffle, Bradley J. & Ganun, Yosef, 2012. "Are income and consumption taxes ever really equivalent? Evidence from a real-effort experiment with real goods," European Economic Review, Elsevier, vol. 56(6), pages 1200-1219.
    4. Raj Chetty, 2009. "The Simple Economics of Salience and Taxation," NBER Working Papers 15246, National Bureau of Economic Research, Inc.
    5. Koichiro Ito, 2014. "Do Consumers Respond to Marginal or Average Price? Evidence from Nonlinear Electricity Pricing," American Economic Review, American Economic Association, vol. 104(2), pages 537-563, February.
    6. 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.
    7. Hirofumi Kurokawa & Tomoharu Mori & Fumio Ohtake, 2016. "A Choice Experiment on Taxes: Are Income and Consumption Taxes Equivalent?," ISER Discussion Paper 0966, Institute of Social and Economic Research, Osaka University.
    8. Kessler, Judd B. & Norton, Michael I., 2016. "Tax aversion in labor supply," Journal of Economic Behavior & Organization, Elsevier, vol. 124(C), pages 15-28.
    9. 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.).
    10. Altemeyer-Bartscher, Martin & Zeddies, Götz, 2017. "Bracket creeps: Bane or boon for the stability of numerical budget rules?," IWH Discussion Papers 29/2016, Halle Institute for Economic Research (IWH).

    More about this item

    Keywords

    Tax; labor supply; average tax.;

    JEL classification:

    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H24 - Public Economics - - Taxation, Subsidies, and Revenue - - - Personal Income and Other Nonbusiness Taxes and Subsidies
    • H31 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Household

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