Monday, March 3, 2008

Observations on taxation

Two recent observations on taxes.

1. The state of Virginia put in place a "Tax Me More Fund"in 2002, that encourages tax payers to contribute more than their prescribed share voluntarily to the state's coffers. But this Fund has had very few takers, collecting a mere $10,217.04 since its inception in 2002. Public generosity reached its high point in 2003 when Virginians forked over $6,602. The low point was in 2006, when the state received a measly $19.36.

Megan McArdle argues in her blog that the failure of the Virginia fund reveals that, "What most of us are really in favor of is higher taxes on other people. If we wanted higher taxes on ourselves, we'd give the money to charity... People do not voluntarily give money to the government. Most people want other peoples' taxes raised, not their own."

She continues, "Most people are not concerned with remedying the injustice of their own high income; they want large public goods that can only be secured by taking a lot of money from other people. They are willing to kick in their own money if they have to in order to secure the coalition, or because they think this is fair. But they are primarily concerned not with their own contribution, but with that of others."

But given the fact that Americans collectively gave away over $35 bn in philanthropic causes in 2007, the problem does not seem to be with giving money for public causes. A plausible explanation would be that though people may be willing to donate money, they expect some form of control over how and where that money is spent. This can be possibly traced back to the general feeling that government's are not likely to spend their money in the most efficient manner and for the most desirable causes.

2. It has long been argued that the salience of taxation is an important determinant in people's willingness to pay taxes. A recent NBER paper by Raj Chetty, Adam Looney, and Kory Kroft finds that tax salience is quite important in purchase decisions because shoppers are inattentive to taxes. They found that when shoppers make their purchases, they simply do not bother to compute tax-inclusive prices.

Their conclusions from a number of experiments are summed up thus, "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 find that posting tax-inclusive prices reduced demand by roughly 8 percent among the treated products relative to control products and nearby control stores. Second, we find that state-level increases in excise taxes (which are included in posted prices) reduce aggregate alcohol consumption significantly more than increases in sales taxes (which are added at the register and hence less salient). Both sets of results indicate that tax salience affects behavioral responses." From these results, they conclude that "agents incur second-order (small) utility losses from ignoring some taxes, even though these taxes have first-order (large) effects on social welfare and government revenue."

It is commonly assumed that it does not matter whether the government taxes consumers or firms. These findings run contrary to this assumption. The authors give the example of a cell-phone plan whose "sticker price" is $39.99 but whose actual price, including taxes and fees levied on the consumer, may be $47.00. If the same taxes were levied on the firm, it could only pass them through by raising the sticker price, thereby reducing demand. They argue that the firms would be more likely to bear the burden of the tax if it were levied on them rather than on the consumers. In contrast, if the tax is levied on the consumer, the demand is likely to be more, though the consumers will end up paying more.

It may be true that consumers are inattentive to taxes, and tend to consume more of a product with a cheaper "sticker price". However, it may not be correct to claim that the consumers will end up paying more in such situations, since it is well established that the incidence of tax is same, whether the tax is levied on the producer or the consumer. The illusion of a cheaper price conceals a market-based allocation of the tax between the producer and the consumer.

In any case the salience of taxes probably explains why surcharges on income taxes and other taxes, generally do not attract the same sort of stiff opposition as raising taxes, though both have the same impact. In light of this observation, governments need to think in terms of imposing some service tax on user charges for specific services so as to limit the opposition to raining taxes.

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