Is Consumer Behavior Shaping the Evolution of Tax Incentives?

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Tax Policy

How consumers make choices in the market place is an important aspect of business. In this article, Hayes Holderness from the University of Illinois College of Law discusses consumer “tax salience” and its impact on state tax incentives

Hayes R. Holderness

By Hayes R. Holderness

Hayes R. Holderness is a visiting assistant professor at the University of Illinois College of Law, where he researches issues of state and local taxation and teaches courses on federal and state and local taxation

When a state imposes a sales tax on a transaction, the cost of that transaction to the consumer increases. A rational consumer will presumptively take that cost into account when making her purchasing decision, and she may even refuse to enter into the transaction. For example, suppose Alice would purchase a BNA subscription as long as the total cost to her for the subscription is less than $100. BNA sets the cost of the subscription at $99.99, and Alice happily subscribes. Now suppose that Alice's home state decides to levy a sales tax on such subscriptions, increasing the total price of the subscription to $105. Alice will no longer purchase the subscription, correct?

A growing field of research into the phenomenon of “tax salience” suggests that the answer is not as clear as one might expect. Tax salience refers to the awareness a taxpayer has of the burden that a tax provision places on her, such that the taxpayer alters her behavior in response. Tax provisions can be fully salient in the sense that the taxpayer reacts to the provision as a rationally economic actor would be expected to react—the taxpayer perceives a $5 tax as a $5 burden. Tax provisions can also be undersalient in the sense that the taxpayer underreacts to the provision—that $5 tax may be perceived as a $2 burden—or hypersalient in the sense that the taxpayer overreacts to the provision—the $5 tax may be perceived as a $10 burden. In one of the recent watershed studies regarding tax salience, Raj Chetty, Adam Looney, and Kory Kroft found that shoppers at brick-and-mortar stores were likely to spotlight on tax-free posted prices when making their purchasing decisions, causing the sales taxes owed on their purchases to be undersalient. The shoppers were ignoring the cost of the taxes to some degree.

The current understanding of tax salience is far from complete, but the idea that taxpayers may respond differently to different forms of tax provisions—even if the provisions are designed to achieve the same substantive goal—is apparently being internalized by state actors. Recent examples of this phenomenon can be found in the actions of a handful of states, such as New Jersey, to relieve Amazon.com (“Amazon”) of its obligations to collect sales and use taxes in those states for a period of time in exchange for Amazon's investment in the states.

Customer-Based Incentives

From a state's perspective, relieving Amazon of its obligation to collect sales and use taxes in exchange for creating jobs and building fulfilment centers in the state may appear innocuous enough. After all, if it did not have a physical presence in the state, Amazon already was not collecting the taxes; the only apparent change from the status quo would be that Amazon would begin investing in jobs and infrastructure in the state. (Admittedly, in-state retailers would have reason to be upset with the allowances to Amazon.) However, this collection obligation relief is appropriately viewed as an economic development incentive—state spending to encourage an out-of-state firm to engage in in-state activities—because the state forgoes revenue that it would otherwise collect in an effort to attract an out-of-state firm. The difference in this form of relief— which I label “customer-based incentives”—as opposed to more traditional forms of economic development incentives, such as income tax credits and property tax abatements, is that the tax relief from customer-based incentives goes directly to the firm's consumers rather than to the firm itself.

How is this the case? Consumers receive direct tax relief when Amazon (or any firm) does not collect a state's sales and use taxes because individual compliance with their use tax obligations is dismally low. Though one might question the propriety of a state taking advantage of use tax non-compliance in order to provide Amazon with an incentive to invest in the state, the fact is when Amazon does not collect the taxes its customers do not pay them and the state does not collect them.

That customer-based incentives provide tax relief directly to consumers rather than the firm itself is important, if not somewhat puzzling. After all, if Amazon can adjust its prices freely, one might suspect that Amazon would simply capture as much of the tax relief provided through the customer-based incentives as it prefers. So why go to the trouble of introducing a new form of incentive; why not just stick with traditional incentives? The answer lies in the salience of the tax relief offered through customer-based incentives; by channeling the tax relief through consumers, the state allows consumer behaviors to affect the value of the incentives to Amazon.

Hypersalience of Tax Relief From Customer-Based Incentives

The universe of consumer behaviors is vast, and there is much still to understand. However, one behavior in particular—“tax-label aversion”—should cause the tax relief from customer-based incentives to be hypersalient to consumers. This hypersalience causes Amazon's customers to overreact to the tax relief, increasing demand for Amazon's products more than rationally expected (that $5 tax cut might now feel like $10 worth of satisfaction). Tax-label aversion refers to the behavior of not enjoying paying things called taxes. Basically, people dislike taxes so much that they derive some satisfaction from not paying them beyond the pure economic value of the taxes. For example, Sussman and Olivola, though a series of surveys, found that people were (i) more likely to drive thirty minutes out of their way to buy a television sales tax free than to drive the same distance for a slightly larger price discount, (ii) willing to stand in line longer for a tax-free purchase than an identically-discounted purchase with tax, and (ii) more likely to prefer tax-free municipal bonds than other bonds, even where the final economic return was equivalent. Thus, customer-based incentives provide customers with tax relief and the satisfaction of not paying taxes—the tax relief becomes hypersalient.

The hypersalience of the tax relief from customer-based incentives offers a solution to the puzzle of the emergence of customer-based incentives. If a firm can increase demand for its products more through the tax relief from customer-based incentives than through equivalent price cuts following its receipt of traditional incentives, then customer-based incentives become appealing. The fact that some states have provided customer-based incentives demonstrates that state actors are internalizing the findings of behavioral research to some degree and recognizing the effect that people's behavior can have on policy outcomes. However, the puzzle of whether states will continue to use customer-based incentives remains.

Looking Into Crystal Ball

It would be a fool's errand to attempt to predict the particular situations in which a state would want to use customer-based incentives. Indeed, in an ideal world, states might not offer economic development incentives in any form; many states are starting to give such incentives stricter scrutiny to ensure they represent money well spent . Even so, some basic comparisons can be made between customer-based incentives and traditional incentives that may inform policy decisions.

Assuming a state has decided to engage in the economic development incentives game, two issues are likely to be among the largest that policymakers are considering: the effectiveness and the fairness of the incentives offered. When targeting a firm that can benefit from customer-based incentives, a state may find that customer-based incentives are the more effective form of incentive because of the hypersalience of the tax relief they offer. That is to say, the state can spend less for the same result using customer-based incentives or some mix of customer-based incentives and traditional incentives. Additionally, the public may view customer-based incentives as fairer than traditional incentives because anyone (even if only nominally) from them simply by choosing to shop with the target firm. On the other hand, the public might find it acutely unfair for the state to rely on consumer non-compliance with the tax law to provide economic benefits to a firm. These are only a few examples of the distinctions between customer-based incentives and traditional incentives, but as they and others are better understood and explored with respect to each unique situation, state actors should be able to make better policy decisions. At a minimum, there are reasons not to dismiss the use of customer-based incentives out-of-hand, and they should be subject to further examination.

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