Benefit Losses Loom Larger than Taxes: The Effects of Framing and Loss Aversion on Behavioural Responses to Taxes and Benefits

Traditional models of labour supply rely on the assumption that individual behaviour is responsive only to the net budget constraint and leisure tastes. However, a substantive body of research points to possible framing effects in labour supply responses to taxation and consequently to tax non-equivalence. Using a lab experiment, this paper examines the presence of differential responses to identical marginal effective tax rates coming from direct taxation and from benefit withdrawal respectively. In an incentivised real-effort task, subjects supply time and effort while facing an incentive structure that is framed as taxation or benefit withdrawal respectively, while yielding the exact same budget constraint. Results indicate that subjects in the benefit withdrawal conditions are more likely to reduce working time compared to both subjects in the tax treatment and a control group where the incentive structure is described without using the language of taxes and benefits. The effect is stronger among loss-averse individuals suggesting that benefit streams may be subject to an ‘endowment effect’. The findings have clear implications for welfare policy design.