How Do Money and Tax Illusion Impact Long-Term Investments? An Experiment

The wealth effects of inflation and taxes on long-term savings, such as retirement investments, can be substantial. Nonetheless, individuals misperceive the impact of both taxes and inflation. Based on a unified theoretical framework, we distinguish between potential cognitive mechanisms underlying tax and inflation misperceptions and derive their implications for investment behavior. Using an incentivized, pre-registered online experiment, we test how these misperceptions influence individual investment decisions. In our baseline setting, inflation and taxation affect investment outcomes equivalently in real or after-tax terms. The results show that — even though all participants were informed about the effects of inflation and taxes on investment returns — investment distortions remain significant in both settings. Distortions driven by money illusion clearly exceed those caused by tax illusion. We find that both rational inattention and anchoring contribute to these distortions, with anchoring appearing more persistent in the inflation setting. Money illusion is therefore not only larger than tax illusion but also harder to undo. Money and tax illusion become more pronounced when future tax and inflation rates are uncertain. We then test the effectiveness of different communication strategies in this setting. Additional tabular information, visualizations, and attention nudges do not systematically reduce money or tax illusion. We show that requiring participants to view real or after-tax consequences before decision making is the most effective intervention; voluntary access has weaker effects, and later display does not systematically reduce the distortions.