The Existence of Inattention to Taxes

Introduction:

The widely established Neo-Classical view predicts that the salience of a tax (whether an excise or/and sales tax) would not have an empirical variation to how consumers adjust their demand. However, current studies in behavioral economics suggest that the inattention of consumers causes varied reactions to changes in salient and non-salient taxes. This may include consumers under-reacting to changes in non-salient taxes (such as a sales tax), or completely ignoring them in some cases (even when the consumer correctly identifies the existence of this addiction cost).

This simple understanding of consumer inattention could greatly benefit firms as well as governments in deciding how to tax items based on a desired outcome.

More interestingly, it is thought that income plays an outstanding role in how accurately individuals perceive the value of goods. Two conflicting yet equally rational theories predict how lower income individuals tend to react to register taxes. One theory states the less fortunate are more attentive, relative to wealthier consumers, to an increase in sales taxes, while the other claims they underreact to the hidden cost. This term paper references various published works in order to: evaluate the existence of inattention by consumers (controlling for social class), analyze reactions to non-salient taxes based on individual wealth, and make conjectures on whether the poor or the rich tend to be more attentive.

Inattention:

A salient tax is an extra cost that is fully visible and accounted for by the consumer. Consumers perceive the value of goods as: V=v+o(1-??) where v is in the visible price of the good, o is the opaque price, and ?? is the degree of inattention. For instance, given that salient taxes are fully visible to the consumer, ?? would be equal to 0 allowing them to correctly estimate the overall price of the good (Fisman, Inattention).

In “Salience Taxation: Theory and Evidence” Raj Chetty, Adam Looney, and Kory Kroft (CLK), construct a field experiment examining consumer inattention. CLK conducted their experiment in a grocery store where they included register taxes to the original pretax price tags shown alongside the good. During their 3-week testing period CLK found that purchases by the treatment group fell by 8% relative to two control groups. Given that the products used had a price elasticity of demand ranging from 1.0 to 1.5, the 8% decrease is coherent with the included 7.35% tax that was initially ignored by consumers. Although lack of consumer knowledge could justify this change in preferences, 75% of subjects were able to identify the sales tax within a 0.5% of the true rate suggesting that consumers were knowable about the sales tax but only when their attention was drawn to it.  This study is consistent with the notion that individuals tend to neglect non-salient taxes and thus have a natural degree of inattention when making purchasing decisions.

Now that the existence of inattention is identified, it is important to examine how individuals react to changes in salient and non-salient taxes in order to measure the affect that such inattention can have on individual preferences.  As mentioned above, Sales taxes are an example of non-salient taxes, considering they are not posted to the initial price of the product, and as a result, consumers do not correctly estimate the value of such taxed goods. In this case the perceived value of the good (referring to V=v+o(1-??)) would be less than the actual value since ?? would be greater than 0, and would even reach 1 if consumers are completely negligible to register taxes.

The research paper “Smoke Gets in Your Eyes: Cigarette Tax Salience and Regressivity” written by Jacob Godin and Tatiana Homonoff (GH) examines the reactions to changes in salient and non-salient taxes. GH chose to conduct their study using survey data on cigarettes (CLK conducted a similar experiment using beer) since both a sales and excise tax are applied to the good. After compiling their data GH displayed their findings in Exhibit 1. Although the data includes several demographic variables in the regression, GH also account for several external factors that may compromise the validity of their results. They include “state-level measures of real income and unemployment rate” in columns 2 and 5 to account for the possibility that cigarette consumption might be correlated with bad economic times when the sales tax also happens to increase. They also account for lower smoking rates among wealthier individuals over time by including a “an interaction between income and a linear time trend” in columns 3 and 6.  Even after external factors are included, GH finds that for every 1% increase in the excise tax rate, smoking fell by approximately “6.5 cigarettes per month” while an increase in the sales tax did not have any noticeable effect on cigarette consumption suggesting that individuals adjust their preferences to excise taxes but are once again, are inattentive to sales taxes.

Although both studies referenced above found that individuals tend to ignore sales taxes, this does not necessarily mean that consumers are completely inattentive. Considering the studies conducted were field experiments, some external factors might not have been accounted for. For example, when visiting the grocery store, consumers might have been impact by the “short run violation of norms” when observing the new posted price tags rather than the ones they are familiar with. Another justification to why consumers might ignore sales taxes is the fact that they are applied to a large number of goods and tend to slightly vary overtime. One experiment created by Dimitry Dubinsky and Alex Rees-Jones (Which will be elaborated on) suggests that consumers are more reactive to changes in non-salient taxes when the increase is significant enough (in their case triple the standard sales tax).  The studies above are not referenced to justify whether consumers completely ignore sales taxes, rather their use outlines that individuals present some degree of inattention and do not value products with absolute accuracy.

Inattention and Wealth:

One important aspect concerning inattention is how it impacts individuals in distinguished physiographic segments more specifically, social class and income. Two conclusions can be determined from researching this manner: one suggesting that low income individuals pay more attention to their transactions and thus would have greater level of attention, the other suggesting that the wealthier present a greater level of financial literacy allowing them to better detect hidden costs.

Jacob Godin and Tatiana Homonoff further their research when analyzing how wealth influences attention to variations in register taxes. GH realized how reactions to a new sales tax could stem from two variables: attention to the higher cost, and/or higher PED for the taxed product. To distinguish the effect of both variables, GH created a formula, the “attention gap, showing how individuals reacted to changes in sales taxes relative to changes in excise taxes (a fully salient tax presenting no level of inattention).  Their empirical findings are shown in Exhibit 2, showing a graph with income percentile on the x-axis, and the attention gap on the y-axis. The results stipulate that as the individual moves to a higher income percentile, the gap between their reactions to non-salient taxes and salient taxes increases. For instance, individuals who are segmented in 60%  income percentile would smoke approximately 10 more cigarettes if the same tax is presented as a sale rather than an excise tax, whereas individuals in the 20% income percentile would smoke approximately 2.5 more cigarettes given similar circumstances. The overall findings are consistent with the notion that lower income individuals pay more attention to non-salient taxes.

In “Attention Variation and Welfare: Theory and Evidence from a Tax Salience Experiment”, Dimitry Dubinsky and Alex Rees-Jones (DJ) create an experiment were participants were asked to make online purchases by selecting their willingness to pay (WTP) for a product after placing them into 3 categories: WTP does not include a tax (the control group), WTP includes the standard tax, and WTP includes triple the amount of the standard tax. All subjects were then instructed to select their WTPs for the product when no tax is included in order to measure their ??. Counter to the results observed by GH, DJ found that as income increased, ?? moved closer to 1. These findings are shown in exhibit 3 where one graph express the findings on ?? for those asked to compute WTP including 3 times the tax amount (or “triple tax arm”), another graph displays ?? based on WTP including the standard tax (“standard tax arm”), and a final graph pooling the results in both categories. DJ surveyed individuals after the experiment was completed and found that most individuals were familiar with their standard tax rate. However, the survey also included questions measuring financial literacy and this is where wealthier individuals scored higher (justifying their ability to better compute ??). Hence, the study concluded that the ability to compute ?? increases with income since wealth and financial literacy present some form of correlation.

Personal Conjecture on Wealth and Inattention:

After analyzing both papers above, it is coherent that the topic in question lacks sufficient findings in concluding how income affects the level of attention to non-salient taxes. Rather than presenting my own theatrical experiment in furthering current research, several conjectures will be made on why both studies conflict based on my knowledge in attention as well as the research referenced in this paper. It is significant to touch upon the varying environments in which both studies were conducted. GH collected data on real life changes in consumer behavior and made empirical conclusions, while DJ constructed a lab experiment to validate their findings. As a result, both studies present varying internal and external validity that should be considered when comparisons of the two are made to answer the topic in question.

I have made my own conjecture to why both papers conflict and present my own interpretation to how individual income affects inattention.  When conducting their research, GH measured an individual’s ability to recognize a change in non-salient taxes on cigarettes and classified those individuals by income. This would mean that every individual has a given baseline (the price of the fully taxed good when they last purchased it) and chose whether or not to recall it when register taxes levying the product varied overtime. As a result, the ability to recognize changes in non-salient taxes can be subject to the individual’s memory rather than just their financial literacy. It is important to recognize GH conducted their study on cigarettes alone, an addictive price inelastic product, thus, their findings do not necessarily reflect consumer behavior across all goods. On the other hand, DJ create a lab experiment measuring consumers’ ability to compute their WTP for a product in two circumstances, with and without a sales tax. In this case, consumers lack a “baseline” for the final price of a product and must compute the non-salient tax rate based on their subjective WTP as well as their knowledge on the register tax rate. This would require some form of financial literacy which is why the poor fared worse than the rich when computing the price of the good including the sales tax. Also, as previously mentioned wealthier individuals are, for the most part, knowledgeable about register tax rates, and can effectively account for it when their attention is drawn to it. Considering the experiment asks individuals to (indirectly) compute the tax rate rather than observes a change in their real-life preferences based on varied sales taxes, wealthier individuals may be more attentive in the lab experiment relative to their own (non-observed) environment. All that is said, I infer that wealthier individuals present a superior ability in computing a non-salient tax however, given that poorer individuals suffer more from being inattentive, they tend to pay more attention to changes in non-salient tax rates relative to the rich where being inattentive is less costly.

Conclusion:

In conclusion, it seems clear that individuals present a form of inattention when making purchasing decisions however, no concise answer can be given on how income impacts attentiveness to non-salient taxes. As previously mentioned, more research needs be conducted on the manner, as the finding would benefit the government in choosing how to levy their taxes (sales vs. excise), reduce optimization issues, and provide tools on influencing preferences of the rich and poor.

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