Sin Taxes Work Best When They’re Put on a Price Tag
For consumption taxes to work as fully intended, retailers need to display the costs.
- December 09, 2022
- CBR - Fiscal Policy
Lawmakers often impose taxes on goods they consider costly to society. The theory is that jacking up costs on products such as sugary drinks and cigarettes will discourage people from consuming them—while raising revenue for the government from people who continue to do so. In 2021 alone, US federal taxes on alcohol totaled $10.2 billion and on tobacco, $12.1 billion.
But these taxes could be working more successfully, according to a team of researchers including Chicago Booth’s Matthew Notowidigdo. They find that the effectiveness of taxes, including sin taxes, is linked to the way they’re presented to consumers. Demand is more likely to fall if the price posted on the shelf shows the “before and after” impact of a tax, as opposed to being applied only at the checkout counter and included on the receipt.
This finding contradicts economists’ and policy makers’ typical assumption that consumers respond to taxes in the same way they respond to higher prices. The takeaway for policy makers: make taxes more visible to consumers.
To determine the effect of product-level tax displays, the researchers analyzed a 2006–14 sampling of NielsenIQ Retail Scanner Data housed at Booth’s Kilts Center for Marketing. The data cover 33.7 million observations from 8,652 grocery stores in 1,460 counties across the United States and represent the top 20 percent of product categories by sales. Notowidigdo and his coresearchers combined these with sales-tax data to estimate how much retailers passed on the tax and how the tax and price changes affected consumer demand.
To account for the possibility that the consumers in the sample might have avoided high taxes by engaging in cross-border shopping, or tried to dodge high store-level prices by switching stores, the researchers lumped similar product codes together and developed a model to compare activity using variations in sales taxes by state, county, and product category. They developed formulas demonstrating how what they call tax salience—or consumers’ ability to differentiate between the price of an item before and after taxes—influences consumer behavior.
The researchers find that the drop in consumer demand following an increase in sales taxes was typically only about 30 percent of the decline that followed an equivalent jump in prices posted at the shelf. This is consistent with sales taxes being less salient to consumers than posted prices.
These findings suggest that taxes are likely to reduce consumer demand more if they are displayed separately at shelf level, alongside the pretax retail prices, or incorporated directly into the posted prices. This way the total cost will be more visible to consumers than if the taxes are tacked on at the checkout counter. “But sugary drinks being designed as sales taxes doesn’t make as much sense,” says Notowidigdo—even though manufacturers and retailers may prefer to collect taxes this way, as the research implies that they face the fallout when greater awareness leads to a drop in consumer purchasing.
Kory Kroft, Jean-William P. Laliberté, René Leal-Vizcaíno, and Matthew Notowidigdo, “Salience and Taxation with Imperfect Competition,” Working paper, April 2022.
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