Sales tax not included: designing commodity taxes for inattentive consumers.

• Author: Goldin, Jacob

NOTE CONTENTS INTRODUCTION I. BACKGROUND CONCEPTS A. Tax Salience B. Efficiency Analysis and Tax Policy C. Low-Salience Taxes and Efficiency 1. Efficiency Benefits of Low-Salience Taxation 2. Efficiency Costs of Low-Salience Taxation II. FINE-TUNING TAX SALIENCE A. Identifying the Efficient Degree of Tax Salience B. Combining High- and Low-Salience Taxes To Implement the Efficient Degree of Tax Salience C. Challenges to Implementing the Efficient Degree of Tax Salience 1. The Efficient Degree of Tax Salience Might Be Outside the Range of Available Tax Instruments 2. Changing Attentiveness to Low-Salience Taxes 3. Taxpayer Learning III. TAX SALIENCE AND OTHER SOCIAL GOALS A. Corrective Taxes B. Distributional Effects of Tax Salience C. Psychic Costs Associated with Low-Salience Taxes D. The Democratic Legitimacy of Implementing [theta] * CONCLUSION APPENDIX INTRODUCTION

With the advent of behavioral economics, scholars have begun to grasp the complexity of forces that drive individual decisionmaldng. A large body of research suggests that even small changes in a policy's design can dramatically affect how individuals behave in response to the policy, even when those design changes do not alter the incentives that individuals face. (1) Armed with this insight, prominent academics and policymakers have argued that governments should take such "behavioral" patterns into account when designing policy. (2)

This Note applies the insights of behavioral economics to an understudied area: the design of tax policy. (3) A series of recent studies suggests that, contrary to the assumptions of conventional tax analysis, the design of a tax significantly shapes taxpayer decisionmaking. These studies find that the more salient a tax is--that is, the more prominent a taxed good's after-tax price--the more consumers take the tax into account when making their purchasing decisions. The lower the salience of a tax, the less taxpayers pay attention and hence, the less they respond to changes in the tax's amount.

In this Note, I argue that the empirical evidence on tax salience has important implications for the design of tax policy. Manipulating the salience of a tax does not affect the substantive choices available to consumers--the salience of the tax does not affect a good's real after-tax price. But because salience affects individuals' consumption decisions, policymakers can manipulate this dimension of tax design to better control the effects of the taxes they impose. Put differently, my claim is that tax salience provides a new design lever that policymakers should use to promote efficiency and other social goals.

The recognition that policymakers should consider salience when setting tax policy is certainly important, but on its own it is not that useful. The challenge for policymaking lies in the next step: determining how salient a particular tax should be. Should taxes be fully salient, entirely hidden, or somewhere in between? And how should governments choose between these possibilities?

Whereas previous scholarship has focused on the binary choice between relying on high-salience versus low-salience taxes, (4) governments are not typically constrained to act in this all-or-nothing manner. Rather, policymakers may employ a combination of high- and low-salience taxes, with a different fraction of each being levied for every taxed good. To illustrate, consider the case of commodity taxation, where a central determinant of salience is whether the tax-inclusive price of a good is prominent at the time consumers make their purchasing decisions. The salience research suggests that consumers are more responsive to posted taxes--taxes that are included in a good's posted price--than to equally sized register taxes--taxes that are added when the consumer checks out at the register. Thus by manipulating the fraction of register and posted taxes levied on a good, policymakers can finely tune the extent to which consumers purchasing that good account for the taxes levied on it.

Once one recognizes that policymakers may fine-tune salience by using a combination of high- and low-salience taxes, a natural question arises: what degree of salience best promotes efficiency? That is, what combination of high-and low-salience taxes will raise some required amount of revenue while generating the minimum harm to consumers? On the one hand, a low-salience tax minimizes the traditional welfare costs of taxation by mitigating the tax's distortionary effects on consumers' purchasing behavior. But on the other hand, low-salience taxes generate new welfare costs by driving consumers to make mistakes. Identifying the efficient combination of high- and low-salience taxes involves trading off between these two competing effects.

This Note develops a number of new guidelines for how policymakers should manipulate tax salience in order to promote efficiency. Using a simple model of consumer behavior, I first derive a baseline formula for how policymakers should set tax salience when they have perfect control over the extent to which consumers account for a given tax. Within a broad range of circumstances, the formula highlights several important results: (x) fully salient taxes are never efficient; (2) fully hidden taxes are only efficient when demand for the taxed good is entirely insensitive to income; (3) high-salience taxes tend to be efficient for luxury goods and for goods that constitute a large share of consumers' expenditures; and (4) low-salience taxes tend to be efficient for goods that are easily substitutable. I then turn to the more practical question of how policymakers might implement the efficient degree of salience identified by the formula and show that utilizing a combination of high- and low-salience tax instruments offers one avenue for doing so. In addition to providing concrete guidelines, these results add important nuances to the existing legal scholarship on tax salience. (5)

Beyond promoting efficient taxation, policymakers can manipulate salience to further other social goals. Most notably, adjusting salience can affect the distribution of a tax's burden, both between producers and consumers, and between high- and low-income consumers. Additionally, Pigouvian taxes, which are intended to affect taxpayer decisionmaking, pose unique considerations for the choice of tax salience: high-salience taxes are more effective at altering taxpayer behavior but less effective at raising revenue. Because distributional considerations and behavior modification are sometimes important elements in the design of tax policy, I consider how policymakers should account for these factors when making design choices that affect a tax's salience.

Although much of my discussion will be theoretical, the question of tax salience is anything but abstract. Policymakers make decisions about a tax's salience--either intentionally or not--whenever a new tax is introduced. In particular, each new commodity tax can either be designed so that it is included in the taxed good's posted price or added on at the register. For example, many states have enacted or are considering enacting taxes on sugary soft drinks. (6) Such taxes can either be implemented by raising the sales tax rate on soft drinks relative to other food items or by taxing manufacturers, in which case the tax is passed on to consumers through an increase in soft drinks' posted price. Although this design choice shapes the salience of the tax--and hence its effects on consumers' soft drink purchasing decisions--to my knowledge its consideration has been absent from the many discussions of the issue.

Similarly, a number of scholars have proposed instituting a national Value Added Tax (VAT) to help stem the growing federal deficit. (7) Like other consumption taxes, the VAT can be designed in high- or low-salience ways. For example, existing state sales tax systems may either be folded into the new VAT system or kept separate. This design choice (among others) has important implications for tax salience, yet despite the attention paid to VAT proposals by academics and policymakers in recent years, the salience aspect of the decision has received scant attention. (8) As this Note will argue, design choices that affect tax salience merit a larger role in discussions of tax policy.

Finally, apart from their practical implications for the design of tax policy, the results presented here speak to broader questions about the appropriate role of government in attempting to reduce its citizens' mistakes. In response to mounting evidence that individuals exhibit systematic cognitive biases when making important decisions, prominent behavioral law and economics scholars have argued in favor of designing institutions in ways that "debias" individuals to improve the quality of their decisionmaking. (9) Such interventions are appealing in the many circumstances in which decisionmakers exhibit cognitive biases, such as when taking out mortgages, choosing a prescription drug plan, or engaging in risky behaviors. However, my results demonstrate that in at least certain contexts, debiasing is actually counterproductive. In particular, I show that even when the government has the option of designing its tax system in a way that prevents taxpayers from making mistakes, taxpayers themselves are actually worse off when it chooses to do so. Thus in the case of commodity taxation, calls for debiasing deserve a skeptical look.

The remainder of the Note is organized as follows. Part I introduces the notion of tax salience and establishes the relationship between salience and efficiency. Part II constitutes the Note's primary contribution: I derive a formula that identifies the efficient degree of tax salience for a taxed good based on the nature of consumers' demand for that good. I also explain how policymakers can implement the efficient degree of salience by combining available taxes of varying...