Tax provisions that reduce deductions and credits by imposing floors and phase‐outs have become an increasingly popular tool used by Congress. However, these provisions also obscure the marginal tax rate, thereby potentially impairing the ability of taxpayers to make optimal decisions.
We investigate the effects of floors and phase‐outs on taxpayers' ability to determine their correct marginal tax rates and how this may affect tax‐rate‐dependent investment decisions. To investigate these potential effects we created an experimental setting in which taxpayers (89 M.B.A. students) were asked to maximize their after‐tax income by choosing between a taxable and nontaxable bond. Each participant was assigned to one of three experimental tax systems: low complexity with no floors or phase‐outs, medium complexity with one floor, and high complexity with both a floor and phase‐out. The effective marginal tax rate was the same in each condition. The results indicate that decision performance was significantly better for participants facing the low complexity system than those in the medium or high complexity systems.