Hidden taxes.

• Author: Galle, Brian

TABLE OF CONTENTS INTRODUCTION I. THE ECONOMICS OF THE FAIRNESS/EFFICIENCY DILEMMA II. BEHAVIORAL EFFECTS OF HIDDEN TAXES A. Forms of Hidden Taxation B. Evidence on Tax Salience C Hidden Taxes and Welfare D. Conflicting Theories of Taxpayer Cognition III. ARE HIDDEN TAXES REALLY HIDDEN? A. Do Taxpayers Anticipate Hidden Taxes? B. Learning and De-biasing IV. POTENTIAL WELFARE LOSSES FROM HIDDEN TAXATION A. Too Much Government? B. Empirics on Size of Government C Distributional Questions 1. Distribution in a Rational Loafing Model 2. Distribution in an Unintentional Ignorance Model V. IMPLICATIONS A. Fairness vs. Welfare. B. National vs. Local Redistribution C. Redistribution Instruments: Tax vs. Substantive Law D. Prices: Tax-Inclusive or Tax-Exclusive? E Democracy vs. Welfare F. Fixing What is Broken CONCLUSION INTRODUCTION

There is a price to be paid for justice, if conventional economic descriptions of Nation are true. In these accounts, fairness and welfare compete: we can redistribute wealth from rich to poor, but only by making society as a whole worse off. (1) Similarly, it is often said that local governments should not, and typically cannot, redistribute wealth, because those from whom wealth is taken will flee to less generous locales. (2) Both of these accounts depend on the assumption, long thought uncontroversial, that taxes change people's behavior. (3) Yet, as this Article surveys, there is startling new evidence that in some cases taxes do not change behavior at all. Taxes can be "hidden," so that they collect revenue or redistribute wealth without also affecting decisions about whether or where to earn or spend. There are many uncertainties that attend this new field, as I also discuss here. But, depending on what future research reveals, we may need to revisit some basic assumptions of tax policy--as well as of public finance economics--more generally.

The fairness-welfare tradeoff follows from the basic economic assumption that in well-functioning markets the choices made by market participants maximize each person's subjective welfare. (4) In order to fund any government program, including one that furthers some redistributive goal, society must raise revenue, usually through some form of tax. These taxes change the price of the goods that are exchanged in the market, altering consumers' decisions. In some instances, where markets are themselves inefficient, taxes may deflect consumer choice closer to the ideal point. But in the absence of externalities or other market failures, the imposition of a tax that changes taxpayer behavior will reduce overall societal welfare.

Thus, the ideal tax is the one that least affects the behavior of actors in efficient markets. (5) Indeed, there is a tradition in public finance economics, usually associated with Ramsey and Mirrlees, arguing that the most efficient tax is one imposed on "inelastic" behavior behavior that is relatively insensitive to price. (6)

At the risk of making my argument here seem obvious, my claim in this Article hinges on the observation that, in order for a tax to induce behavioral changes from the taxpayer, the taxpayer must usually first be aware of the tax. Similarly, if the size of the behavioral distortion is related to the size of the tax bill, then a diminished awareness of the bill's economic burdens should also diminish the distortion. It follows that an unnoticed tax is, like a tax on highly inelastic behaviors, potentially more efficient than more obvious excises.

These points are academic if taxpayers are perfectly rational and possessed of full information about their own finances. However, a growing literature, both in and outside the laboratory, suggests that, in fact, taxpayers exhibit different responses to taxes that are more or less "salient"--that is, noticeable or easy to process. (7) This is an old idea, but evidence in support of it is new. (8) For example, Amy Finkelstein reports that drivers are less sensitive to toll increases when tolls are debited electronically rather than paid in cash. (9) Similarly, Chetty, Looney, and Kroft find that shoppers are more responsive to sales taxes when those taxes are posted on the shelf, rather than computed at the register. (10) In this paper, I describe any of these tax designs, in which the behavioral effects of the tax are less than predicted by classic economic theory, as a "hidden" tax. (11)

My aim here is to explore the implications of hidden taxes for public policy. It is possible that hidden taxes could revolutionize the design of some government programs. For example, shifting to hidden taxes might permit society to redistribute considerably more wealth to the poor while holding the deadweight losses of tax constant, or, conversely, hold redistribution constant while growing the economy. The relative salience of taxes versus other forms of redistribution, such as regulation, should inform our choice of redistributioe instrument. And hidden taxes could alter the conclusion of many pure tax policy questions, such as the choice whether to stimulate the economy through rebate checks rather than reduced payroll withholding, whether to redistribute income locally or nationally, or the choice between sales tax and Value-Added Tax.

I argue, though, that all these outcomes depend on a number of antecedent questions, many of which have not yet even been considered in the literature. Perhaps most importantly, existing models of hidden tax assume what might be termed a rational ignorance or "intentional" model of tax salience. That is, the models assume that taxpayers neglect taxes as a result of a calculated determination that the disutility of calculating tax exceeds the present discounted value of avoiding the tax. (12) However, other contributions to the behavioral economics literature imply that there are alternative explanations, in which individuals are not capable of taking into account the real future utility cost of present decisions. (13) I term these other theories collectively the "unintentional ignorance" model. (14)

As I show here for the first time in the literature, the policy implications of hidden taxes differ radically depending on whether the intentional or unintentional model is more accurate. Under the intentional model, taxes will not remain hidden when the tax bill becomes large, because the benefits of avoiding the tax will eventually exceed the benefits of avoiding having to think about tax. In that case, hidden taxes are probably not a solution to the fairness-welfare tradeoff, because they cannot raise enough revenue. In addition, depending on which model ultimately prevails, hiding a tax may change who pays the tax. Hidden taxes are likely progressive in a rational ignorance model, but regressive otherwise.

Additional possible qualifications to the hidden tax story have been recognized by other scholars, but not explored in any great depth. (15) Thus, another contribution of this Article is to examine in close focus the possibility that taxpayers might anticipate hidden taxes or that learning and experience might over time increase the salience of the hidden tax. In addition, I want to highlight the fiscal federalism aspects of the problem, which thus far also have not been addressed by the literature. Changes in the salience of a tax may affect Tiebout sorting--that is, the choice of which bundle of local taxes and government services we wish to consume. (16) That possibility implies that hidden taxes might best be employed, if anywhere, at the national level.

Finally, I point out that the new findings that hidden taxes change consumer behavior distinguish these developments from what has come before. The long-standing view of hidden taxes focused solely on their political implications, in particular the possibility that low salience may also present opportunities for self-serving tax increases by public officials, leading to inefficiently high tax rates. (17) However, as I review here, there has never been any convincing empirical evidence that low salience results in higher taxes. I argue that, in fact, that view rests on several faulty assumptions. For instance, in a world where some voters know that taxes are hidden from others, the usual incentive to free-ride on lobbying efforts of others unravels, so that hidden taxes may actually lead to more anti-tax lobbying and lower taxes.

In short, the fact that some taxes may be less salient than others can be more than a happy accident; it may well be a feature of the tax system we should intentionally seek to develop, just as with other proposals for the optimally efficient tax. However, before we go down that road, with its troubling implications for democratic theory, it might be wise to first consider some possible limits on the efficiency-enhancing potential of hidden taxes.

Part I of this Article offers readers new to the tax literature a short overview of the economics of Nation. Part II explains hidden taxes: their potential forms, existing evidence that they may affect behavior, the welfare implications of these findings, and the uncertain cognitive science behind what we have observed. Part III considers two possible objections to the claim that hidden taxes might increase social welfare: taxpayers may anticipate hidden taxes, or learn to recognize them. Similarly, Part IV analyzes the potential welfare losses from hidden taxes, such as from inefficiently large government, or from redistribution from poor to rich. Part V previews some of the policy implications that would result if hidden taxes genuinely could increase welfare, including the chance that we might face a conflict between open and democratic government and greater social welfare.

1. THE ECONOMICS OF THE FAIRNESS/EFFICIENCY DILEMMA

   This Part sketches the economic underpinnings of the progressive tax dilemma. Readers already familiar with the economics of taxation may safely skip to the last paragraph.

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