Why tax reformers should learn about ignorance

Would the rich pay more tax if we replaced the current income tax system with a flat tax? What about if we abolished the income tax and raised the GST?

If you answered “no” to both these questions, then you’re in line with what virtually all tax experts - left and right - believe is true in developed countries. But when researcher Joel Slemrod put these questions (PDF 101KB) to a sample of the US population, 41 percent said “yes”. They thought that under a flat income or consumption tax, the rich would pay more tax. Assuming the experts are correct, it looks like 4 out of 10 Americans fundamentally misunderstand their tax system.

What is startling about this is that most tax analysis generally begins from the premise that people have a perfect understanding of the system. For example, a major policy focus in Australia over recent years has been on ensuring that the tax and benefit system does not overly penalise the move from welfare into work. Implicitly, most of those who argue for lowering “effective marginal tax rates” assume that people are well-informed about the system, and can calculate how getting a job or changing their hours will affect their tax bill and welfare cheque.

In many contexts, the economic assumption of “perfect information” is a reasonable approximation of the real world. But when it comes to complex systems like taxes and family benefits, it becomes increasingly tenuous to claim that the typical person knows the system.

Lately, economists working in the field of “behavioural public finance” have begun to implement a series of randomised experiments to test the extent to which salient information matters. One of the leaders of this field is Raj Chetty, a lanky whiz kid who at the ripe age of 29 is a full professor at Harvard University.

With co-author Emmanuel Saez, Chetty ran an experiment in which tax agents were randomly required to inform low-income workers about the parameters of the Earned Income Tax Credit (EITC), an in-work benefit for poor families. Tax agents who complied with the program induced a substantial increase in earnings among their clients. Indeed, Chetty and Saez estimate that a small amount of additional information (a two-minute tutorial and a follow-up letter) led to a big increase in earnings. “Teaching the tax code” had the same impact as a one-third increase in the generosity of the credit.

The results of this experiment fly in the face of conventional economic wisdom. Under the US EITC, poor families can be eligible for thousands of dollars annually. For economists, observing taxpayers who are ignorant about the basic parameters of the system is like seeing pedestrians stepping over a pile of $20 notes strewn on the footpath.

In another exercise, Chetty and his co-authors Kory Kroft and Adam Looney showed that it is not only information about taxes that matters, but also whether that information is “in your face”. For this experiment, they exploited the fact that product prices in the US do not include sales taxes. Working with a grocery store, they posted tax-inclusive prices on a series of randomly selected products, and watched to see how it affected consumer behaviour. When surveyed, consumers typically knew that tax would be applied at the checkout - yet posting a tax-inclusive price on the shelf still reduced demand by 8 per cent. (Subsequent Harvard research backs up the finding that sales taxes are especially salient: incentives to buy a hybrid car are seven times more effective if delivered through sales tax waivers than via income tax credits.)

Although I know of no Australian surveys that have comprehensively measured “tax literacy”, there are reasons to think that Chetty’s findings might apply here. The expansion of family tax benefits and child care benefits to the middle class - and the sheer frequency with which these policies change - make it pretty improbable that everyone is up to date with the latest policy. And Australians are world-leaders in our use of tax agents. When three-quarters of individual taxpayers require professional help to lodge their return, it’s surely a hint that the system has grown too complex.

Speaking to the National Press Club last November, Treasury Secretary Ken Henry told the tale of his conversation with “Jim from Jericho”, and emphasised the wisdom of “bar room conversations of practical people”. But as well as listening to what voters already know, tax reformers should focus on issues of information and salience. Indeed, the way a policy is designed and understood might be as important as its price tag.