Undercover Economist

April 10, 2010 12:06 am

The only thing worse than high taxes is noticing they’re high

A new strand of economic analysis reveals that visible reminders of taxes directly affect consumers’ behaviour

Not all taxes are created equal. They vary in obvious ways, such as who has to send money to the government. They vary in subtle ways, too – such as who actually pays the tax.

For instance, the government may ask the buyers of computers to pay a £50 computer purchase tax; or they may ask the sellers of computers to pay a £50 computer sales tax. It does not take much economics to show that it makes no difference to the taxman who writes the cheque: the after-tax price that buyers and sellers pay will be the same either way.

The same economics will also show who ends up absorbing more of the tax: it is whoever is less price-sensitive. If manufacturers and retailers are willing to expand dramatically or contract production in response to the price the market will bear, it will be computer buyers who pay most of the tax. If potential buyers will be driven away by modest price increases, it will be computer sellers who swallow the tax instead. If both buyers and sellers are price-sensitive, the tax will simply shut down the market.

All this is old news to micro-economists, but now a new strand of economic analysis is changing the way we think about taxation.

Raj Chetty, a young economics professor at Harvard, has been trying to understand how we perceive taxes. Taxes that seem equal to micro-economists may not seem equal to shoppers, or voters, and the difference matters.

In one of Chetty’s most memorable experiments, conducted with Kory Kroft and Adam Looney, the researchers persuaded a supermarket to change the way it displayed certain prices in store. Attached to the standard label, which advertised the price before sales tax, was an extra tab that also gave the post-tax price. The extended label should have made no difference: it was not obscuring the original information, but adding something that almost every shopper already knew. (Chetty’s team confirmed this with a survey: shoppers knew of the existence of the sales tax and most of them knew its level.)

By comparing what happened in the supermarket in the weeks before and after the experiment, Chetty was able to show that the labels made a big difference, cutting demand by about 8 per cent. This is an astonishing result: remember that the new labels told customers nothing they didn’t already know. It just brought it to the front of their minds.

This research on “tax salience” has practical implications. Because customers often ignore taxes that are tacked on at the checkout, they will end up paying a larger share of the tax. Perversely, the political appeal of such taxes may be lower, because voters are reminded of the tax every time they go shopping. A tax-inclusive price – such as Britain’s VAT – shapes purchasing decisions more, but is politically less visible. Small wonder rumours abound that VAT is to rise to 20 per cent after the election.

Chetty’s research also tells us about benefits. He complains about the way tax credits are paid out in the US. These credits should encourage more work, because, in effect, they boost the hourly wages of poor households by applying a negative income tax. But they are not salient: people receive a cheque from the government at the end of the year, and most people don’t understand how it boosts their hourly income. British tax credits are paid more frequently, but again, it is not always clear to recipients how their extra hours are linked to extra cash from the government. A more salient benefit would probably encourage longer hours and help lift families out of poverty. Such benefits have to be noticed to be effective – something you wouldn’t think politicians needed telling.

Tim Harford’s latest book is ‘Dear Undercover Economist’ (Little, Brown)

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