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Human Irrationality May Be a Boon For Tax Reform

2013 January 30
by Eric Horowitz

Whenever Republicans and Democrats pretend they’re going to reform the tax code the hypothetical agreement always has the same general outline: Lowering rates while ending deductions and loopholes. Although there are never details beyond the aforementioned seven words — thereby making it impossible to gauge public opinion on reform ideas — it is worth asking a simpler question. Are people even able to make of sense of what it means for there to be lower rates and fewer deductions?

A new study from a group of German researchers suggests that the answer is no. In two experiments participants were presented with a number of potential ways their income could be taxed. The plan that resulted in the lowest tax burden had a relatively high rate, but taxes were levied only on the net income that remained after deductions. The plans with lower rates tended to tax gross income (i.e. no deductions), and thus they resulted in larger tax burdens. The researchers found that people irrationally preferred lower rates. In the first experiment fewer than 10% of participants ranked the tax plans in a a fully rational manner, and in the second experiment less than a third of subjects chose the option with the lowest tax burden.

Our results show that the majority of individuals do not make rational tax decisions based on the actual tax burden but rather use simple decision heuristics. This leads to an irrationally high impact of changes in nominal tax rates on the perceived tax burden. Taxpayers favor tax options that apply a lower tax rate on their gross income over a higher tax rate applied on their net income despite the lower actual tax burden of the latter option. This result suggests that politicians could combine increasing fiscal revenues and decreasing subjects’ tax perception.

In the real world, exposure to tax reform ideas and the ensuing formation of opinions is much messier than it is in a lab. Real deductions also have salient names and purposes, and that means people are more likely to be aware of their disappearance. On the other hand, taxes are withheld from paychecks based on rates, whereas money from deductions generally comes in at the end of the year. Thus people may ultimately be more likely to notice the savings from lower rates than the costs from fewer deductions.

The irony of the study is that it suggests the ignorance of humanity may make it easier to enact good tax policy. Because people are bad at understanding the difference between net and gross income, lowering rates and closing loopholes could raise more revenue, create better incentives, and make people incorrectly believe they’re paying less money in taxes. In a place with functioning political institutions that might be enough to establish a solid coalition with the potential to enact real reform.
Blaufus, K., Bob, J., Hundsdoerfer, J., Kiesewetter, D., & Weimann, J. (2013). Decision Heuristics And Tax Perception –An Analysis Of A Tax-Cut-Cum-Base-Broadening Policy Journal of Economic Psychology DOI: 10.1016/j.joep.2012.12.004

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