Katuščák (2009) “Effects of Predictable Tax Liability Variation on Household Labor Income,” unpublished manuscript

Economic theory assumes that taxpayers use their true marginal tax rate (MTR) to guide their economic decisions. However, complexity of the personal income tax system implies that taxpayers may incorrectly perceive true marginal prices and incentives. We first develop an up-dating model that formalizes this conjecture. A prediction of the model is 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 is not in fact changing. Then, assuming that taxpayers react to their perceived after-tax price as economic theory would suggest, we test this prediction empiri-cally by examining 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 in the given tax year. Using identification strategy based on eligibility discontinuity, we find that losing the credit reduces 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. This finding is inconsistent with the taxpayers being fully rational and fully informed, which suggests imperfect ex-post understanding of changes in the tax schedule