No. 108: Firms’ Tax Misperception

Abstract

Tax considerations can play a critical role in business decisions. However, it is not the actual tax burden but decision-makers’ perception of it that shapes how taxes affect managerial reasoning. This study investigates how owners and managers of small and medium-sized firms (SMEs) perceive their firm’s average (ATR) and marginal tax rate (MTR), the extent to which these perceptions deviate from actual rates, and how such tax misperceptions are incorporated into business decisions. Using a unique dataset of survey responses on perceived tax rates, we quantify the magnitude of tax misperception and identify its key drivers. Our results reveal that a substantial proportion of SME decision-makers significantly misperceive their tax burden: over 57% (53%) misestimate their ATR (MTR). Sole proprietors and decision-makers in partnerships tend to overestimate their ATRs, while corporate decision-makers typically overestimate tax rates on retained profits but underestimate both ATRs and MTRs on distributed profits. Irrespective of the firm’s legal form, we find that tax misperception systematically decreases with firm size and increases with the complexity of the tax system, limited tax literacy, and dissatisfaction with the tax system. Importantly, this misperception is not benign. It is likely to distort investment decisions and shape attitudes to tax reforms, particularly under progressive tax schedules. Our findings underscore the need for policymakers and researchers to account for firms’ misperception of tax regulation and tax burden when designing and evaluating policies and develop tools to mitigate it to improve the effectiveness of tax reforms and enhance trust in government.