The Importance of Tax Adjustments When Evaluating Wage Expectations*

• DOI: http://doi.org/10.1111/sjoe.12296
• Published date: 01 April 2019
• Date: 01 April 2019

Scand. J. of Economics 121(2), 578–605, 2019

DOI: 10.1111/sjoe.12296

The Importance of Tax Adjustments When

Evaluating Wage Expectations*

Stefan Kl¨oßner

Saarland University,DE-66123 Saarbr ¨ucken, Germany

s.kloessner@mx.uni-saarland.de

Gregor Pfeifer

University of Hohenheim, DE-70593 Stuttgart, Germany

g.pfeifer@uni-hohenheim.de

Abstract

Using elicited expectations of future gross salaries, we evaluate characteristics causing German

students to make larger or smaller estimation errors. While students seem to underestimate actual

salaries by 18 percent, we show that these errors are highly attributable to misconceptions of

the progressive income tax. Developing a suitable adjustment procedure, we correct students’

estimates and find that errors decline by 12 percentage points. Conducting regression analyses,

wereveal strong connections with students’ age, gender,work experience, secondary school track,

and knowledge about student loans. These results change notablyif not controlling for students’

misconceptions of the tax system.

Keywords: Human capital; progressive(income) tax; returns to education; wage differentials

JEL classification:H24; I26; J24; J31

I. Introduction

A central assumption of human capital theory is that people select their ideal

type and extent of schooling to maximize life-cycle utility – or income.

This view is closely linked to the premise that people are able to forecast

correctly and rationally the income streams of alternative investments in

education. Thus, ex ante (perceived) earnings – in contrast to ex post

(realized) earnings – affect the extent to which higher education will be

pursued. However, it is questionable whether students have an accurate

perception of how alternative educational decisions actually influence their

prospective income. Indeed, as Lusardi and Mitchell (2014) summarize,

*The authors are grateful for valuable remarks from Nadja Dwenger and Aderonke Osikominu

as well as from participants of the Warsaw International Economic Meeting (WIEM) and the

Annual Meeting of the Vereinf ¨ur Socialpolitik (VfS). Jan Fr¨uhwald provided excellent research

assistance.We particularly thank Stefan Witte,who contributed to earlier versions of this research.

Administrative support by Saarland University’s officials is gratefully acknowledged.

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The editors of The Scandinavian Journal of Economics 2018.

S. Kl¨oßner and G. Pfeifer 579

many people around the world are financially illiterate, which leads us to

consider that financial knowledge is a form of human capital.

Within this framework, we want to shed light on students’ expectations

regarding future salaries, and hence to evaluate their ability to make

accurate predictions of labor market outcomes. Using a rich dataset of

more than 2,000 applicants for Saarland University, Germany, we test

whether students have knowledge of their own potential gross salary as

well as knowledge of salaries for other graduates, on average. We test

the accuracy of this knowledge regarding the student’s chosen major and

regarding alternative choices. In so doing, we use elicited expectations,

examining whether students’ estimates are representative for actual salaries

observable in the labor market, and whether potential estimation errors are

driven by specific characteristics.

Our results show that students substantially underestimate actual starting

salaries by about 18 percent. However, using specific items from our survey,

we can show that estimation errors are highly attributable to students’

misconception of the progressive income tax system. We explicitly asked

students to estimate net equivalents of given gross salaries in order to

test their understanding of the tax code. Corresponding results suggest

that students do not perceive the progressivity of income taxation at all,

rather expecting a constant or even decreasing tax rate for increasing

gross salaries. As a consequence, we adjust students’ salary estimates

and re-evaluate their knowledge of future labor market outcomes. For this

purpose, we provide a stepwise adjustment procedure, which first computes

perceived net estimates and then re-translates those figures into adjusted

(i.e., corrected) gross estimates. As a result of the adjustment, students’

estimation errors drop by 12 percentage points, showing that applicants do

have a correct idea about what salaries to expect in the future when tax

issues are properly taken into account. Even though applicants’ adjusted

expectations are in line with labor market outcomes, some level of error still

remains (i.e., 6 percent, on average). When conducting regression analyses,

we find that the accuracy of students’ estimations is particularly driven by

age, work experience, the secondary school track, knowledge about student

loans, and gender. Notably, we show that using unadjusted expectations of

future salaries would yield considerable changes across several covariates

in our model, resulting in both economically and statistically different

estimates.

While our work can be viewed as an extension to the stream on

financial (il)literacy, it is most closely related to a rapidly growing body of

literature concerning elicited expectation measures. Betts (1996), Dominitz

and Manski (1996), and Wolter (2000) show that there is substantial

variation in students’ beliefs about future wages. While such studies reliably

demonstrate that students perceive a positive return to college education (see

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The editors of The Scandinavian Journal of Economics 2018.