Optimal Tax Salience

Author
Abstract

Recent empirical work suggests that how an individual responds to a tax depends at least in part on the tax's salience. The more salient a tax is, the more taxpayers adjust their demand in response to changes in the taxed good's after-tax price. If tax salience affects behavior, a natural question follows: How salient should a government's revenue collection system be? I investigate this question by considering
the problem faced by a benevolent government choosing between high- and low-salience commodity taxes to meet a revenue constraint. I show that low-salience taxes introduce two offsetting welfare effects: on the one hand, they reduce the excess burden traditionally associated with distortionary taxation by dampening consumers' substitution away from the taxed good; on the other hand, low-salience taxes introduce new welfare costs by causing consumers to make optimization errors when deciding how much
of each good to purchase. Under certain conditions, I show that governments can utilize a combination of high- and low-salience commodity taxes to achieve the first-best welfare outcome, even without employing a lump-sum tax. I also derive a simple and intuitive formula that characterizes the optimal mix between
high- and low-salience taxes needed to obtain this outcome. Under the optimal policy, the low-salience tax is strictly non-zero, and the ratio of low- to high-salience taxes is 1) increasing in the compensated own-price elasticity of demand for the taxed good, 2) decreasing in the income-sensitivity of the taxed
good, and 3) decreasing in the taxed good's share of the budget. Finally, high-salience taxes tend to be efficient when consumption of the taxed good generates negative externalities.

Year of Publication
2012
Number
571
Date Published
03/2012
Publication Language
eng
Citation Key
8730
URL
Working Papers