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Effects Of Predictable Tax Liability Variation On Household Labor

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Executive Summary

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. The authors of this paper 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 is not in fact changing. They 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.

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