The economics of complex tax incentives

I’ve long wondered about this question, now there is a paper about it, from Johannes Abeler and Simon Jäger, forthcoming, “Complex Tax Incentives,” American Economic Journal: Economic Policy.  The abstract is here:

How does tax complexity affect people’s reaction to tax changes? To answer this question, we conduct an experiment in which subjects work for a piece rate and face taxes. One treatment features a simple, the other a complex tax system. The payoff-maximizing output level and the incentives around this optimum are, however, identical across treatments. We introduce the same sequence of additional taxes in both treatments. Subjects in the complex treatment underreact to new taxes; some ignore new taxes entirely. The underreaction is stronger for subjects with lower cognitive ability. Contrary to predictions from models of rational inattention, subjects are equally likely to ignore large or small incentive changes.

I would think the real world danger is that intermediaries will teach people how to game complex tax systems over time.  Still, the actual tax incentive faced by individuals may not be so transparent even to informed and strategic advisors, nor are the advisors always able to communicate actionable advice to the individuals facing the taxes.

Here is Simon’s paper on the returns to German higher education.

Comments

What is the IQ of a frog in a pot?

I would interpret this result as meaning that a complex tax system becomes more regressive over time, as it saps the ability of the least resourceful to resist continual addition to their burdens.

For this to be true the 'least resourceful' would have to also be the least successful in terms of acquiring the tax base (i.e. income, wealth, property etc). We all heard the story of the rock star who made millions but it all disappeared because he didn't pay attention to his finances and trusted 'people' to do it for him. It doesn't follow to me that those who do the best are necessary also masters of personal resourcefulness.

We all did hear that story, but everyone else saw its note worthiness in the oddity of the event.

Also, sales and utility taxes and regulatory passthroughs are consumption taxes.

Tax complexity is basically a form of price discrimination that allows higher overall taxes without creating disincentives to work. There isn't much deadweight loss from high tax rates on people who don't pay much attention to tax rules. It's the same logic as coupons. If you charge a lower price to people who are willing to jump through a few hoops for the lower price, you can continue charging the higher price to less price-sensitive customers.

I think this is right. For all the talk of the "Bush Tax Cuts" I think the actual effect was just to drive many people except for the truly high income into AMT (or if you were already paying AMT, you saw no benefit) - but you didn't see a lot of discussion of that and I don't think a lot of people realized that. Similarly, for Obamacare, for all the discussion of the merits of Obamacare, it's amazing how little discussion there was of what was essentially a 3.8% flat tax surcharge on net investment income (above $200K/250K). Figuring out your marginal tax rate is pretty complicated. I know the tax law pretty well, and until recently, I assumed the LTCG tax rate was 15 or 20% even if you are under AMT - which in theory, it is, but effectively, it's not, until you fully phase out the AMT exemption (because LTCG phases out the exemption). In other words, most people focus on the headline marginal rates, but if you don't look at it closely, you don't really understand your marginal rate.

Given those with cash are investing as much or more since the Obamacare 3.8% tax on investment, do think it is so complex that savers did not understand they should put the money under a mattress to avoid taxes, or they were rational in understanding that more investment income means more investment income whether the tax rate is higher or lower?

As I look back over my life, the worst financial decisions I've made have occurred from listening to these kinds of debates and stupidly picked the option that avoids paying taxes, like not selling stock to pay cash to avoid paying something like 30% tax rates on gains and instead borrowing to buy, and then the stock goes down 30% with still a large gain to pay taxes on, then more to 50%.....

When selling one house and buying a new one, I again made the mistake of buying a house more expensive than the cost basis of the old one instead of renting or finding something half the price, all to avoid paying taxes. I have twice the house I need and twice the operating costs based on "taxes on investments" and I'm more locked in and lose more when the market goes down. At least I got rid of the debt asap because it was easy to figure out that not paying interest was cheaper than paying interest to get lower taxes from the interest deduction.

No one had and incentive to talk about the increase in the tax on investment income. The detractors did not since most non investors are not aware that it is taxed and a lower rates than income from work the majority would want the rate to be even higher, especially on the rich, and the people who favored Obamacare did not want to talk about new taxes.

Any time you want to avoid paying taxes on your investments, send me your savings and I will pay any gift taxes, and pay the taxes on investing the money you give me to avoid paying taxes on the investment returns.

Bet you think that paying taxes is not that bad compared to having nothing to tax.

"Teach" is not used appropriately in the post.

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