Standard economic theory assumes that individuals understand the taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. schedule they face and alter their work and savings behavior accordingly in response to tax changes. We have previously discussed how the Earned Income Tax CreditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. (EITC) for example may cause individuals to save less and reduce their number of hours worked, given how the phase-out of the credit affects marginal tax rates as workers earn more income. However, a complex tax structure could lead taxpayers to misinterpret the tax incentives they face. A new paper published in the American Economic Review finds that recipients of the Child Tax Credit (CTC) in particular reduce their reported wage income when they discover that they have lost their credit due to a child in the family turning 17, even though their marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. has not changed.
The CTC offers a credit of up to $1,000 for each qualifying child. The credit amount, like the EITC, depends on the family’s earnings. However, when the child turns 17, the family loses all of the credit. For this reason, fully informed parents should be able to anticipate this change in their tax owed, and will not adjust their number of hours worked. Parents who do not anticipate this change, but recognize that they have experienced a negative income shock, will work more once they have lost the credit. Parents who do not understand why their tax liability has increased will attribute part of the credit loss to a change in their marginal tax rate. Consequently, this group will reduce their labor supply.
This paper’s authors use tax returns filed by married couples between 2004 and 2011 that have a child in the family turning 17 during this period. A wide range of household incomes are represented in this sample, from $30,000 to $100,000. They find that these households reduce their reported wage income by 0.5% relative to households that retained the credit for another year. Specifically, they estimate that individuals attribute between one-quarter and one-half of their credit loss to a change in their marginal tax rate. This behavior is concentrated among younger, poorer households, without self-employment or capital income.
The results of this paper are broadly consistent with the literature on taxpayer’s understanding of their tax schedules, or what economists call “tax salience.” Raj Chetty and his coauthors for instance found in this 2013 paper that taxpayer behavior in response to the EITC differs across geographic locations. These findings suggest that policymakers should consider taxpayer perceptions when considering the welfare implications of a new tax policy.
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