Salience and Taxation: Theory and Evidence

A central assumption in public \u85nance is that individuals optimize fully with respect to the incentives created by tax policies. In this paper, we test this assumption us-ing 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 \u85nd that posting tax-inclusive prices reduced demand by roughly 8 percent among the treated products relative to control products and stores. Second, we \u85nd that state-level increases in excise taxes (which are in-cluded in posted prices) reduce aggregate alcohol consumption signi\u85cantly more than increases in sales taxes (which are added at the register and hence less salient). Both sets of results indicate that tax salience a¤ects 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 rst-order (large) e¤ects on social welfare and government revenue. Using this theoretical framework, we develop elasticity-based formulas for the e ¢ ciency cost and incidence of commodity taxes when agents do not optimize fully. We are very grateful to So\u85a Berto Villas-Boas, Reed Johnson, and Steve Flaming for help in imple