NBER WORKING PAPER SERIES THE SIMPLE ECONOMICS OF SALIENCE AND TAXATION

This paper derives empirically implementable formulas for the incidence and efficiency costs of taxation that account for tax salience effects 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. The results are derived using simple supply and demand diagrams and familiar notions of consumer and producer surplus. The approach to welfare analysis proposed here yields robust formulas because it does not require specification of a positive theory for why agents fail to optimize with respect to tax policies. Raj Chetty Department of Economics Harvard University 1805 Cambridge St. Cambridge, MA 02138 and NBER chetty@econ.berkeley. edu 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 optimize imperfectly with respect to many types of tax and transfer policies. For example, Raj Chetty, Adam Looney, and Kory Kroft (2007) analyze the e¤ect of salienceon behavioral responses to commodity taxation. They nd that commodity taxes that are included in the posted prices that consumers see when shopping (and are thus more salient) have much larger e¤ects on demand.1 Kelly Gallagher and Erich Muehlegger (2008) show that more salient sales tax waivers given at the time of purchase have seven times as large an e¤ect on hybrid vehicle purchases as income tax credits of an equivalent amount. Chetty and Emmanuel Saez (2009) show using a eld experiment that providing simple information about the marginal incentive structure of the Earned Income Tax Credit leads to signi cant changes in subsequent labor supply and earnings behavior. In Xavier Gabaix and David I. Laibsons (2006) terminology, these studies show that many tax policies are shrouded attributes.  Such inattention and imperfect optimization may be prevalent in the case of taxation because tax systems are complex and nontransparent. Income tax schedules are 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). Motivated by this empirical evidence, this paper analyzes the implications of salience e¤ects and other optimization errors for the welfare consequences of tax policy. The challenge 1I 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, I de ne salience in terms of the visibility of the tax inclusive price because I focus on behaviors that optimally depend on total tax inclusive prices rather than behaviors which depend on the tax rate itself.