Nova workboard

a blog from young economists at Nova SBE

Hidden Taxation: Out of Sight, Out of mind

Economic theory often relies on many assumptions. These assumptions may very often be at odds with real world behavior. For example, economists often portray humans as homo economicus; a perfectly rational, self-interested human who always behaves optimal to achieve a subjectively-defined end (sounds almost like a psychopath). However, most people are not homo economicus, most people are simply homo sapiens (which ironically is Latin for “wise man”). This fact is important to bear in mind when considering the effects of taxation on behavior. People do not fully optimize their decisions with respect to tax policies. Moreover, people are often inattentive to tax policies, which often are complex and nontransparent in practice.

In an interesting paper posted in the American economic review the effects of tax salience is investigated. Tax salience refers to the visibility of the tax-inclusive prices and how this affects economic behavior. Using a field experiment in a U.S. supermarket the researchers manipulates the visibility of the tax-inclusive price on a set of consumer goods. This is possible since the U.S. sales tax is added to the bill at the register and not shown on the price tag. In addition to the field experiment the researchers estimates the effects on demand of changes in the tax-inclusive price due to both direct product price changes and changes in the sales tax rate.

According to standard economic theory the unveiling of the tax inclusive price on the price tag should not affect demand as the price of the good in reality is unchanged, at least for the cyborg Homo Economicus. Moreover, the behavioral response of Homo economicus to a change in the tax-inclusive price should be independent of whether the change is due to a change in the direct product price or a change in the sales tax. So, how does the quite ordinary homo sapiens behave?

The researchers find that the demand decreases when the tax-inclusive price is unveiled. They also find that people generally underreact to changes in taxation compared to direct product price changes, when the tax is not directly observable. This is not what the homo economicus predicts. There are especially two explanations to why we observe this behavior. First, people may not be well informed about the tax or tax rate. Second, the salience of taxation matter. Even though their results may be just a freak accident it seems to be some truth to their findings and most people will probably feel familiar with the results.

These results of the effects of hidden taxation have several important impacts on public policy. Because people don´t always know what they pay in taxes politicians may be incentivized to raise taxes, potentially harming the consumer. Another implication is how this kind of hidden taxation may be used to introduce less distortionary taxes. However, there are clearly some ethical considerations that should be taken into account as most people would very much like to know both what they are paying and to whom.


Author: studentnovasbe

Master student in Nova Sbe

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