A central assumption in public finance is that individuals optimize fully with respect to the incentives created by tax policies. In this paper, we test this assumption using two empirical strategies. First, we conducted an experiment at a grocery store where we posted tax-inclusive prices for 750 products subject to sales tax for a three week period. Using scanner data, we find that posting tax-inclusive prices reduced demand by roughly 8 percent among the treated products relative to control products and nearby control stores. Second, we find that state-level increases in excise taxes (which are included in posted prices) reduce aggregate alcohol consumption significantly more than increases in sales taxes (which are added at the register and hence less salient). Both sets of results indicate that tax salience affects behavioral responses. We propose a bounded rationality model to explain why salience matters, and show that it matches our evidence as well as several additional stylized facts. In the model, agents incur second-order (small) utility losses from ignoring some taxes, even though these taxes have first-order (large) effects on social welfare and government revenue. Using this theoretical framework, we develop elasticity-based formulas for the efficiency cost and incidence of commodity taxes when agents do not optimize fully.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
13330.
Length: Date of creation: Aug 2007 Date of revision: Handle: RePEc:nbr:nberwo:13330
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Find related papers by JEL classification: D11 - Microeconomics - - Household Behavior - - - Consumer Economics: Theory H0 - Public Economics - - General J0 - Labor and Demographic Economics - - General K34 - Law and Economics - - Other Substantive Areas of Law - - - Tax Law
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Ricardo Reis, 2004.
"Inattentive Consumers,"
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Manuel Amador & Iván Werning & George-Marios Angeletos, 2006.
"Commitment vs. Flexibility,"
Econometrica,
Econometric Society, vol. 74(2), pages 365-396, 03.
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Manuel Amador & Ivan Werning & George-Marios Angeletos, 2003.
"Commitment Vs. Flexibility,"
NBER Working Papers
10151, National Bureau of Economic Research, Inc.
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