No. 108: Firms’ Tax Rate Misperception: Measurement, Drivers, and Distortionary Effects

Abstract

Decisions-makers in firms are expected to use perceived rather than actual tax rates and hence their decisions can be substantially biased by misperception. We quantify firms’ misperception of their average tax rate (ATR) and marginal tax rate (MTR) and identify drivers of this tax rate misperception. Using survey data on German firms, we find that the share of firms considerably misperceiving their ATR and MTR exceeds 65% and 57% respectively. Further, we illustrate firms’ impaired comprehension of the tax schedule reflected by the relation between ATR and MTR. We find sole proprietorships and partnerships on average considerably overestimate their ATR anchoring at the top marginal tax rate. While corporations show no uniform tax misperception patterns for retained profits, they tend to strongly underestimate ATRs and MTRs on distributed profits. Irrespective of the legal form, we find misperception is mainly driven by tax regime complexity, lack of tax knowledge and dissatisfaction with the tax system. Surprisingly, even though many firms report using the ATR instead of the appropriate MTR in their investment and financing decisions, which suggests that they underestimate their tax burden, this bias is partially attenuated by their ATR misperception. Overall, our findings demonstrate that policymakers and researchers can benefit from incorporating firms’ tax rate misperception when estimating firms’ tax response and evaluating tax policies.