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Journal of Business Economics

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20-10-2016 | Original Paper

Affective reactions influence investment decisions: evidence from a laboratory experiment with taxation

Authors: Martin Fochmann, Johannes Hewig, Dirk Kiesewetter, Katharina Schüßler

Published in: Journal of Business Economics | Issue 6/2017

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Abstract

We experimentally investigate the effect of taxation of gains and losses on investment behavior. Based on the insights of economic research and psychological concepts, we expect subjects to react to taxation with behavioral and affective changes. Our main results are threefold: first, we show that taxation on gains and the possibility to deduct losses bias investment behavior, but in different directions. Since net payoffs are identical across all tax scenarios and therefore the same investment behavior is to be expected, these differences are in contrast to what a standard theory would predict. Second, we observe that different tax regulations have different effects on the affective and cognitive perception of our subjects. Third, with respect to possible connections of the affective and cognitive ratings, tax regulations, and investment decisions, we are able to show that arousal and risk perception fail to influence the decision making of participants, while there is a highly significant influence of valence perception on choice patterns.

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From January 2013, the Zeitschrift für Betriebswirtschaft (ZfB) is published in English under the title Journal of Business Economics (JBE). The Journal of Business Economics (JBE) aims at encouraging theoretical and applied research in the field of business economics and business administration, promoting the exchange of ideas between science and practice.

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For an example of more recent research of dual processing in neuroscience, see Brocas and Carrillo (2014).

In the finance literature, the disposition effect describes the robust behavioral anomaly that investors are reluctant to realize capital losses, whereas capital gains are sold too early (see, for example, Odean 1998).

The design modifications are as follows: First, for time reasons, subjects receive an initial endowment of 15 € in our experiment instead of “earning” this amount of money through a real effort task. Second, we do not implement the tax control treatment and capped deduction treatment for time reasons. Third, we implement a new treatment (loss deduction treatment) that completes our 2 × 2 design described below to investigate the individual effects of taxation on gains and loss deduction. Fourth, we reduce the number of decision situations per treatment from 20 to 10 for time reasons. Fifth, after the lottery task is completed, we measure subjects’ affective and cognitive perception of investment situations.

As a standard recruiting procedure was not available for us, we recruited our subjects by notification. In particular, we designed a flyer with all relevant information about the experiment and sent this to different lecturers. As the experiment was conducted at the faculty of Economics and Management, we distributed the document only to lecturers from this faculty. The lecturers were asked to present this flyer at the beginning of their courses. If a student was interested in participating, he/she was asked to send an email to the experimenter’s email address displayed at the flyer.

Although there is considerable variation in completion time across individuals, we found no systematic relationship with any of the other variables.

The instructions are presented in Appendix 1.

We confront our subjects with control questions to test their comprehension. For this purpose, a subject has to correctly calculate net payoffs for each treatment. A wrong answer is not punished and does not lead to any negative consequence. Specifically, a subject with a wrong answer is neither excluded from the experiment nor from the analyses. If an answer is not correct, the subject is given a further attempt to solve the problem correctly.

To avoid income effects and strategies to hedge the risk across all decision situations, only one out of the 40 decision situations determines pay.

In experimental economics, the term “treatment” is used to refer to a particular condition of the experiment. In our experiment, we have four different conditions (gains and losses are not subject to taxation; gains are subject to taxation, but not losses; losses are subject to taxation, but not gains; gains and losses are subject to taxation) and thus four different treatments.

In our experiment, we use the same lottery outcomes as presented in Fochmann et al. (2012). However, we reduced the number of decision situations per treatment from 20 to 10.

Although there is probably no real-life example for such a tax treatment, this combination completes the 2 × 2 design and therefore helps to investigate the individual effects of taxation on gains and loss deduction.

Indeed, the willingness to take risk and thus the decision behavior depends on the individual risk preference. However, for our research question, we are only interested in the different decision behavior of an individual across the treatments (treatment differences) and not in the exact decision behavior in one treatment. As a subject is confronted with identical lotteries in net terms in all treatments and as a subject participates in each treatment (within-subject design), decision behavior of this subject should not differ between the treatments from a standard theoretical perspective (under stable risk preferences across treatments).

The order of the tax situations to be rated is randomized for each subject.

Subjects are also asked to indicate valence, arousal, and cognition of specific lotteries. For this purpose, we confront each subject with two exemplary lottery pairs after the experiment again and ask them to rate the low-risk as well as the high-risk alternative in every tax condition. The order is randomized for each subject. We apply the same questions, but we use (in line with the instructions) “business opportunity” instead of “tax situation”. As we are only interested in how the perception of each tax regulation influences the decision behavior of our participants and not in how the perception of a specific lottery effects behavior, we will only focus on the general tax situation ratings in the following.

We decided to only report the number of low-risk lottery choices. As the number of decision situations (i.e., lottery choices) is ten in each treatment, the number of decisions for the high-risk lottery equals ten minus the number of decisions for the low-risk lottery.

Furthermore, we explicitly tested for gender differences. However, we did not observe any differences between female and male subjects with respect to the lottery choices, the ratings or the change of choices and ratings across the treatments.

As robustness tests, we further run nonparametric tests and fixed effects logistic regression to analyze the treatment differences. The test results confirm our ANOVA results and are presented in Appendix 3.

As robustness tests, we further run nonparametric tests to analyze the treatment differences. The test results confirm our ANOVA results and are presented in Appendix 3.

To ensure that the decision situations are identical in net terms in—for example—the taxation on gains treatment and baseline treatment, the (positive) gross payoffs are higher in the former than in the latter. Please notice that the increase of the gross payoff itself is not assumed to lead to an additional utility shift because we assume that subjects still use the net payoff for their decisions. Furthermore, subjects compare—within one decision situation—the low-risk and high-risk lottery under a certain tax regime and not between two tax regimes and thus are not directly confronted with the gross payoff increase.

Tax aversion refers to the idea that individuals bear an extra utility loss from paying taxes in addition to the utility loss resulting from the monetary consequences of paying taxes. See, for example, Kirchler (1998), Fennell and Fennell (2003), McCaffery and Baron (2006), Hardisty et al. (2010), Kallbekken et al. (2011), Sussman and Olivola (2011), Hundsdoerfer et al. (2013), and Blaufus and Möhlmann (2014).

This is in line with Prospect Theory (Kahneman and Tversky 1979) if the presented gross payoff is assumed to be the reference point. According to this theory, a payoff (like in this case the net payoff) below this reference point is perceived as a loss.

Again, this is in line with Prospect Theory if the presented gross payoff is assumed to be the reference point. A payoff (like in this case the net payoff) above this reference point is perceived as a gain.

In other words, subjects perceive loss deduction as a possibility to reduce negative payoffs which has stronger effects than the reduction of positive payoffs by taxation.

For example, the legislator could assess affective perception by using survey methods before the tax reform is introduced. How to measure the affective perception of different tax regulations is, however, an open question and should be answered by future research.

In addition, one further interesting research question for future research would be to analyze whether subjects with certain risk preferences react differently to the tax frame. Unfortunately, the data regarding subjects’ risk preferences or level of loss aversion is not available for us.

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Title: Affective reactions influence investment decisions: evidence from a laboratory experiment with taxation
Authors: Martin Fochmann
Johannes Hewig
Dirk Kiesewetter
Katharina Schüßler
Publication date: 20-10-2016
Publisher: Springer Berlin Heidelberg
Published in: Journal of Business Economics / Issue 6/2017
Print ISSN: 0044-2372
Electronic ISSN: 1861-8928
DOI: https://doi.org/10.1007/s11573-016-0838-0

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