Salience and Taxation: Theory and Evidence

83 Pages Posted: 27 Aug 2007 Last revised: 22 Oct 2007

See all articles by Raj Chetty

Raj Chetty

University of California, Berkeley - Department of Economics; National Bureau of Economic Research (NBER)

Adam Looney

Brookings Institution; U.S. Department of the Treasury, Office of Tax Analysis (OTA)

Kory Kroft

University of Toronto

Date Written: August 2007

Abstract

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.

A revised version of this paper with new theoretical results may be downloaded here:
http://elsa.berkeley.edu/~chetty/papers/taxsalience_aer.pdf

Suggested Citation

Chetty, Nadarajan (Raj) and Looney, Adam and Kroft, Kory, Salience and Taxation: Theory and Evidence (August 2007). NBER Working Paper No. w13330, Available at SSRN: https://ssrn.com/abstract=1009790

Nadarajan (Raj) Chetty

University of California, Berkeley - Department of Economics ( email )

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Berkeley, CA 94720-3880
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National Bureau of Economic Research (NBER)

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Adam Looney (Contact Author)

Brookings Institution ( email )

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Washington, DC 20036
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2027976068 (Phone)

HOME PAGE: http://www.brookings.edu/experts/looneya.aspx

U.S. Department of the Treasury, Office of Tax Analysis (OTA) ( email )

1500 Pennsylvania Ave. NW
Washington, DC 20220
United States

Kory Kroft

University of Toronto ( email )

Toronto, Ontario M5S 3G8
Canada

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