Salience and Taxation : Theory and Evidence

This paper presents evidence that consumers underreact to taxes that are not salient and characterizes the welfare consequences of tax policies when agents make such optimization errors. The empirical evidence is based on two complementary strategies. First, we conducted an experiment at a grocery store posting tax inclusive prices for 750 products subject to sales tax for a three week period. Scanner data show that this intervention reduced demand for the treated products by 8 percent. Second, we nd that state-level increases in excise taxes (which are included in posted prices) reduce alcohol consumption signi cantly more than increases in sales taxes (which are added at the register and are hence less salient). We develop simple, empirically implementable formulas for the incidence and e¢ ciency costs of taxation that account for salience e¤ects as well as other optimization errors. Contrary to conventional wisdom, the formulas imply that the economic incidence of a tax depends on its statutory incidence and that a tax can create deadweight loss even if it induces no change in demand. Our method of welfare analysis yields robust results because it does not require speci cation of a positive theory for why agents fail to optimize with respect to tax policies. E-mail: chetty@econ.berkeley. edu, adam.looney@frb.gov, kroft@econ.berkeley. edu. We are very grateful to So a Berto Villas-Boas and Reed Johnson for help in implementing the experiment and to Christopher Carpenter, Je¤rey Miron, and Lina Tetelbaum for sharing data on alcohol regulations. Thanks to George Akerlof, David Ahn, Alan Auerbach, Douglas Bernheim, Kitt Carpenter, Judith Chevalier, Stefano DellaVigna, Amy Finkelstein, Michael Greenstone, Caroline Hoxby, Shachar Kariv, Peter Katuscak, Botond Koszegi, Erzo Luttmer, James Poterba, Matthew Rabin, Ricardo Reis, Emmanuel Saez, Jesse Shapiro, Andrei Shleifer, Dan Sichel, Uri Simonsohn, anonymous referees, and numerous seminar participants for helpful comments and discussions. Laurel Beck, Gregory Bruich, Matt Grandy, Matt Levy, Ankur Patel, Ity Shurtz, James Sly, and Philippe Wingender provided outstanding research assistance. Funding was provided by NSF grant SES 0452605 and the Hoover Institution. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research sta¤ or the Board of Governors of the Federal Reserve. Appendices and stata code for the empirical analysis are available on Chettys website. A central assumption in public economics is that agents optimize fully with respect to tax policies. For example, Frank P. Ramseys (1927) seminal analysis of optimal commodity taxation assumes that agents respond to tax changes in the same way as price changes. Canonical results on tax incidence, e¢ ciency costs, and optimal income taxation (e.g. Arnold C. Harberger 1964, James A. Mirrlees 1971, Anthony B. Atkinson and Joseph E. Stiglitz 1976) all rely on full optimization with respect to taxes. Contrary to the full optimization assumption, there is accumulating evidence which suggests that individuals are inattentive to some types of incentives.1 Inattention and imperfect optimization could be particularly important in the case of taxation because tax systems are complex and nontransparent in practice. Income tax schedules are typically highly nonlinear, bene t-tax linkages for social insurance programs are opaque (e.g. social security taxes and bene ts), and taxes on commodities are often not displayed in posted prices (sales taxes, hotel city taxes, vehicle excise fees). In the rst half of this paper, we investigate empirically whether individuals optimize fully with respect to taxes by analyzing the e¤ect of salienceon behavioral responses to commodity taxation. Speci cally, we show that commodity taxes that are included in the posted prices that consumers see when shopping (and are thus more salient) have larger e¤ects on demand.2 In Xavier Gabaix and David I. Laibsons (2006) terminology, our empirical analysis shows that some types of taxes are shrouded attributes. In the second half of the paper, we develop a simple method of characterizing the welfare consequences of taxation when agents optimize imperfectly with respect to taxes. We study the importance of salience empirically using two complementary strategies: (1) an experiment in a grocery store and (2) an observational study of the e¤ect of alcohol taxes on alcohol consumption. The experiment was implemented at a supermarket over a 1Recent studies of inattentive behavior include prices vs. shipping fees (Tanjim Hossain and John Morgan 2006, Jennifer Brown, Hossain, and Morgan 2008), nancial markets (Stefano DellaVigna and Joshua Pollet 2008), and rebates for car purchases (Meghan Busse, Jorge Silva-Risso, and Florian Zettelmeyer 2006). See DellaVigna (2008) for additional examples and a review of this literature. 2We use tax salience to refer to the visibility of the tax-inclusive price. When taxes are included in the posted price, the total tax-inclusive price is more visible but the tax rate itself may be less clear. There is a longstanding theoretical literature on  scal illusionwhich discusses how the lack of visibility of tax rates may a¤ect voting behavior and the size of government (John S. Mill 1848). Unlike that literature, we de ne salience in terms of the visibility of the tax-inclusive price because we focus on behaviors that optimally depend on total tax-inclusive prices rather than behaviors which depend on the tax rate itself.