This paper presents evidence that consumers underreact to taxes
that are not salient and characterizes the welfare consequences of
tax policies when agents make such optimization errors. The
empirical evidence is based on two complementary strategies. First,
we conducted an experiment at a grocery store posting tax inclusive
prices for 750 products subject to sales tax for a three week
period. Scanner data show that this intervention reduced demand for
the treated products by 8 percent. Second, we find that state-level
increases in excise taxes (which are included in posted prices)
reduce alcohol consumption significantly more than increases in
sales taxes (which are added at the register and are hence less
salient). We develop simple, empirically implementable formulas for
the incidence and efficiency costs of taxation that account for
salience effects as well as other optimization errors. Contrary to
conventional wisdom, the formulas imply that the economic incidence
of a tax depends on its statutory incidence and that a tax can
create deadweight loss even if it induces no change in demand. Our
method of welfare analysis yields robust results because it does
not require specification of a positive theory for why agents fail
to optimize with respect to tax policies.
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