Abstract
Economic theory assumes that taxpayers use their true marginal tax rate (MTR) to guide their economic decisions. However, due to complexity of the tax system, taxpayers may incorrectly perceive their MTR, with implications for incentives.
We first develop an updating model that formalizes this conjecture. It predicts that an unexpected increase in the previous year's tax liability pushes up the perception of the MTR in the current year, even though the MTR does not, in fact, change.
We then examine whether household labor income responds to predictable (but not necessarily predicted) lump-sum variation in the previous year's tax liability due to loss of eligibility for the Child Tax Credit when the eligible child turns 17. Using an identification strategy based on an eligibility discontinuity, we find that losing the credit reduces, ceteris paribus, parental labor income in the year following the loss of the credit.
This result is robust to a variety of tests and different data sources. Because it cannot be explained by an income effect or credit constraints, such a finding is inconsistent with the taxpayers being fully rational and fully informed.
We interpret it as being driven by a substitution effect on labor supply due to imperfect ex-post understanding of the change in the tax schedule.