Investment Behavior and the Biased Perception of Limited Loss Deduction in Income Taxation

Abstract

We use a laboratory experiment to study the extent to which investors' choices are affected by limited loss deduction in income taxation. We first compare investment behavior in the no tax baseline to a tax control setting, in which the income from investments is taxed. We find that investors significantly reduce their risk-taking as predicted by theory. Next we compare the baseline investment choices to choices under three different types of income taxation. We observe that risk-taking is significantly increased with partial and with capped loss deduction, but is unaffected by a tax system that allows no loss deduction. Since in all these treatments the after tax outcomes of the prospects were identical, we conjecture that investors have a positively biased perception of partial and capped loss deduction that promotes their willingness to take risks.

The Non‐Equivalence of Labour Market Taxes: A Real‐Effort Experiment

“…Fochmann et al . () study how investment decisions change with the framing of taxes. Their experimental results show that the possibility to deduct losses from an income tax leads to significantly riskier investments (again, their treatments are equivalent under full rationality).…”

The Biased Effect of Aggregated and Disaggregated Income Taxation on Investment Decisions

“…Investors, for example, may overestimate the positive effect of loss deduction in a tax scheme. Fochmann, Kiesewetter, and Sadrieh (2012) have shown a perception bias exists for incomplete loss deduction, but the question remains open whether a similar or a different bias is observed in a setting with complete loss deduction. If the effect of loss deduction is overestimated, investors will tend to increase their risky investments.…”

“…They find a perception bias in that labor provision is higher with a consumption tax than with an equivalent income tax. Fochmann et al (2012) also study a real-effort situation with a proportional income tax. Keeping the net wage constant, they vary the tax rate and the gross wage.…”

“…The complicated macroeconomic setting in Riedl and Van Winden (2007), however, makes it difficult to pinpoint the perception bias in taxation. Fochmann, Kiesewetter, and Sadrieh (2012) present a simpler experimental study on investment decisions when taxation only allows incomplete loss deduction. They show that the positive effect of incomplete loss deduction (both partial and capped deduction methods) on income is overestimated in comparison with the cases without loss deduction and without taxes.…”

Behavioral Optimal Taxation: The Case of Aspirations

“…However, evidence that human behavior systematically deviates from rational choice is abundant. There are now a considerable number of papers documenting non-rational behavior relevant for taxation (e.g., Kerschbamer and Kirchsteiger, 2000;Sausgruber and Tyran, 2005;Chetty et al, 2009;Sausgruber and Tyran, 2011;Fochmann et al, 2012;Blumkin et al, 2012;Carpenter et al, 2016;Weber and Schram, 2017). The abundance of evidence of nonrational behavior has lead scholars to call for or engage in the development of behavioral models for welfare evaluations (Bernheim and Rangel, 2005;McCaffery and Baron, 2006;Kőszegi and Rabin, 2008;Riedl, 2010;Mullainathan et al, 2011;Chetty, 2015).…”