Overreaction to Capital Taxation in Saving Decisions

Abstract

This paper studies the response of saving decisions to two alternative types of capital taxation, i.e., wealth tax and capital income tax. I conduct a lifecycle experiment using Amazon Mechanical Turk, where subjects make dynamic saving decisions. The subjects exhibit an overreaction to wealth taxes but not to capital income taxes: they save significantly less with introducing a wealth tax than with a financially equivalent decrease in capital returns. Furthermore, I build a parsimonious behavioral model of individual optimization to characterize this misreaction. Finally, I quantitatively illustrate the implication of misreaction bias for optimal capital taxation analysis in an overlapping generations model with the household’s misreaction bias. The results show that a household’s underreaction (overreaction) bias generates a welfare gain (loss) for the economy. The optimal capital tax rate decreases as households exhibit greater overreaction bias and vice versa.