Investment behavior and the biased perception of limited loss deduction in income taxation

Abstract

a b s t r a c tWe 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.

Tax Loss Offset Restrictions and Biased Perception of Risky Investments

“…Furthermore, we assume that the tax on gains or the tax refund for losses are anticipated by investors and thus influences the (post-tax) preferences. 13 This assumption is in line with findings in experimental studies that provide evidence that investors include taxes in their investment calculations (Fochmann, Kiesewetter andSadrieh 2012, Fochmann andWolf 2015).…”

“…If loss offset regulations are rather generous, investors are very loss averse or assign a huge weight to loss probabilities, taxation is likely to increase the preference value of the investment (behavioral tax paradox). Thereby our model explains why subjects in laboratory experiments mentally overestimate losses and the possibility to offset losses (Fochmann, Kiesewetter and Sadrieh 2012) and provides a descriptive theory for the experimental evidence for tax-induced biased perceptions of risky investments. Our model also reveals that investors' evaluation of a risky investment is very sensitive to loss aversion and probability weighting while it is less responsive to the risk attitude.…”

“…Our model theoretically describes effects found in laboratory experiments as the mentally overestimation of losses or loss offset opportunities in Fochmann, Kiesewetter and Sadrieh (2012) or Fahr, Janssen and Sureth (2014) and Amberger, Eberhartinger and Kasper (2016). Thus, we provide a descriptive model for the yet unexplained experimental evidence for tax-induced biased perception of risky investments.…”

Biased effects of taxes and subsidies on portfolio choices

“…In a recent experiment, Fochmann et al (2012) find that a tax perception bias influences risk-taking behavior when subjects are able to offset losses from their taxable base. In this paper, we investigate whether a perception bias also has an effect in a more general investment problem with different types of government intervention.…”

Real Tax Effects and Tax Perception Effects in Decisions on Asset Allocation

“…In particular, Swenson considers only the case of a full loss offset, while King and Wallin avoid losses completely and, thus, are not able to examine tax effects on losses. Therefore, Fochmann et al (2012a) distinguish among three loss offset scenarios in their experiment: no, partial, and capped loss deduction. In each decision situation, participant's task is to choose between two risky lotteries with different expected values and risk.…”