Last Thursday, I had the pleasure of listening to Hunt Alcott, Assistant Professor of Economics at NYU, present some new work on the impact of taxation when consumers are inattentive to certain types of price signals.
Earlier in this course we learned about different types of taxes: corrective taxes that “correct” a market failure and increase social welfare and distortionary taxes that raise revenue, but decrease social welfare. Dr. Alcott and co-authors’ provocative hypothesis is that when consumers make mistakes in thinking about different types of prices, you can construct taxes that are not corrective, but nonetheless increase social welfare. Literally, you are taxing people to make them better off. This is “We’re from the government and we’re here to help” taken up a notch.
To understand this hypothesis we need to define the particular type of mistake that consumers are making. This mistake is what the authors call “inattention.” Drawing on the literature, they argue that people are often more price responsive to purchase prices than to other implicit prices or ancillary costs. For example, people are more responsive to purchase price than shipping and handling costs or sales tax rates. They argue that the long run fuel costs associated with operating a vehicle are similar ancillary costs and consumers may be inattentive to these costs when making their car purchase decision.
Under these circumstances, taxing gas-inefficient vehicles, or implicitly taxing them through a CAFE standard, can actually make inattentive people better off. The tax increases the relative purchase price of the gas-guzzler and decreases the relative purchase price of the fuel-efficient car. The tax distorts relative prices in a way that makes consumers recognize the long-term costs of operating the vehicle (which they would otherwise be inattentive to) by embedding them in the upfront purchase cost. The increase in social welfare from this type of “internality” tax holds even if there are no externalities (carbon emissions etc.) from the burning of the additional gasoline.
To say that taxing people to make them better off is politically infeasible (and undesirable) is an understatement. But the idea that people make mistakes in trading off current costs and longer terms costs is well-established in the literature. It is worth thinking of less paternalistic ways to help people make tradeoffs that ex post, they would agree made them better off. The authors offer four broad categories of such policies all of which try to target the policy to customers most likely to be inattentive. While any of these may work theoretically it is often quite difficult to target customers who are inattentive. How do you tell if a customer is inattentive to gas prices or really just likes trucks?
Full paper: Allcott,Hunt, Sendhil Mullainathan, and Dmitry Taubinsky “Externalizing the Internality“
I wonder whether people are inattentive gas prices or just have a really high discount rates, so that future costs don’t weigh heavily into decisions regarding current consumption. If people really do have large discount rates for future consumption and thus are properly maximizing their utility, it seems like this source of tax would actually make them worse off–an issue raised in the last line in of your blog.
Just like the premises of conducting contingent valuation, the definition of service and the value of policy-induced change in that service should be clarified to make sure that interviewers thoroughly understand the questions, thus their answers could genuinely reflect the opportunity cost underlined.
Policy makers assume consumers’ behavior would follow some psychological/social rules when they design policy. However, as market shows, consumers’ behaviors are capricious and some of them are not rational, or to say “inattentive”, which makes the effectiveness of the well-designed policies faded and intangible.
the question Lori proposed in the article,I think, is how to make the policy REACH consumers.
Informative labeling might be a way out.
An illustrative big tag pasted on the car telling costumers the benefit they’ll gain or how much they are gonna save by operating this type of car compared to the other ones. It might function as well as the “distort tax”.
In a word, policy is not merely political term but also a cognitional term. Policy , when combined with (consumer) education and marketing, could be expected to reach its end means.
It really is a shame that things that would make society better off as a whole seem to almost always be politically infeasible. It makes me wonder what would happen if there was a law that banned all economically inefficient actions and mandated that everyone operate such that economic efficiency was being attained. Would society really be better off? Or would it only be better off in some areas, but not in others? This is to tough a question for me or maybe anyone to answer, but I would really like to know the answer.
I always like to think of myself as an informed consumer, but it is easy to understand that most people aren’t. When I first started looking to buy a car the Prius was only a few years old and still very pricey in comparison to other cars,. Even without any economics classes or a calculator I figured that at some point down the road the money I would save on gas would equal out the increased purchase price of the Prius with other car models. If advertisements for cars included some statistic along those lines (if you drive as much as an average American, your gas-pump savings will equal the price difference between this car and x other model in so many years) like Jeimei mentioned it would hopefully create awareness. But then again, with gas prices fluctuating the way they have over the past 10 years who can tell how that time-period would change not to mention the discount rate.
And what if someone works in an industry where they need a large van or truck? They get penalized for their job field? I can understand the premise of a tax like this if all cars served the exact same function but had different mileage and prices, but the fact that each car has a unique value makes this tax unrealistic.
When making car purchases, people often don’t balance the intended use of the vehicle with the vehicle’s features and capabilities. For example, a staggering amount of people own a giant pickup truck or SUV that can tow a huge load and drive offroad, but never end up utilizing these capabilities. This is because a car is increasingly seen as a status symbol. Consumers try to translate size and engine power into success. For the most part, our society buys in. A tax is most appropriate for this sort of buying behavior. One concern is that the consumer base for these large, expensive, and fuel-inefficient vehicles have the incomes to pay the tax and keep driving these cars. Revenue is raised for the government, but little is accomplished in trying to decrease purchases of fuel-inefficient cars. Also, the tax may hit hardest on the wrong type of consumer, the ones who actually need such a vehicle for their job. This consumer is typically blue collar and often doesn’t have the large incomes to compensate for such a tax, and would face a choice between a more expensive vehicle or an underachieving cheaper vehicle.
Given these quirks of the large car market, it would be great if we could tax one’s necessity for such a vehicle, but that is almost impossible to quantify. It may be possible to differentiate between these two types of consumers- the wealthy who want the car and the blue collar who need the car- by raising taxes on the “luxury” version of a vehicle and keeping modest taxes on the base models that are more commonly used by the “need” group.
I agree with Thomas’ comment, above. There are many confounding factors that contribute to consumers buying SUVs, trucks, and other inefficient cars that they don’t need for their “intended” purposes. As mentioned in Dr. Bennear’s blog, an inattention tax might raise social welfare in such situations, but would be politically infeasible. However, given the recent insurgence of US patriotism and buying American automobiles, what about an advertising push that touted the economic benefits of buying more environmentally friendly cars? US manufacturers are developing electric and hybrid vehicles, so making a concerted effort to convince Americans that buying local low-emissions cars may be a win-win: benefit the environment and our economy. Regardless of the approach, it’s clear that environmental and economic efficiency can go hand in hand.
While we have concentrated exclusively on models assuming rational individuals acting in their own best interest, our own Prof. Ariely has become famous for demonstrating that this person does not exist. I think any honest self-reflection on our own purchasing decisions would confirm this. Effective policy design must face this reality and incorporate not only microeconomics, but also behavioral economics. The concept isn’t new, with a prominent example being cigarette taxes, which have proven effective at lowering smoking rates despite the large elasticity of demand for an addictive product. The emerging literature on financial “nudges” to guide policy should be embraced. As to political feasibility, an approach that could have success is a non-revenue generating “tax”. E.g., a tax on one product is directly tied to one or more incentive based “nudge(s)” where other price “inattention” exists.
The cars driven abroad (except for the Middle East) are usually small, compact and gas-efficient – which begs the question – why are we so different?
Prices play a large role – but I think marketing and consumer perception is a major driver in this country. Even if we start taxing gas-inefficient cars (which in a way, we already do through CAFE standards and tax breaks for hybrids, etc), I think people will still continue to buy large gas guzzlers because of the “image” it provides them. Driving Escalades, Hummers or Bentleys have been promoted not just by celebrities (athletes, musicians, reality-stars, etc), but policy makers and heads of state are also driven in these cars. This seems to influence the average consumer’s perception of what kind of car they should “aspire” to buy.
There has been a recent shift by some celebrities and politicians to environmentally friendly cars (including the Prius), however, marketing campaigns need to change to reflect not just the better environmental, and economic choice – but also the “image” choice. This seems to be a superficial approach to a daunting problem, however, in a country where “image” and celebrity culture seems to be very important – we need to start fighting fire with fire. So lets start promoting Teslas, Volts, etc – with the same vigor as the gas-guzzlers. Yes, that means fashion weeks, celebrity award events, reality shows, UN meetings, the White House, etc.
Effort can come from two sides. I do think the nudge-inducing policy suggested for firms is one major side of it as fuel efficiency and saving money at the pump in advertisements and sales pitches will hit home for consumers before the thought of environmental benefits kick in. Firms study and know how to communicate to consumers, and collectively market forces can hopefully shift toward more fuel efficient vehicles.
Also, the government applying pressure on the consumer side has seemed to work in other countries like the UK. I understand that we already tax gas-inefficient vehicles through CAFE, however, the UK taxes everyone with a car and those with large SUVs/4X4’s are penalized more of course. Light trucks are being used for passenger cars which are not the purpose they are intended for. Many people eventually got fed up with paying such a high annual tax on their SUV and they later purchased smaller vehicles. Of course you do see large SUVs on the road in the UK; however these are people who generally have a higher WTP for that tax. As for those who need a large vehicle for business or particular hauling, perhaps different tax rates or a program can be set through behavioral screening.
After admitting that I love big cars (not huge just larger that my 1996 honda accord) in my last blog, I was interested in reviewing Professor Alcott’s article Externalizing the Internality. The language, Alcott and his co-writers used, such as “inattention” and “misoptimization,” struck a chord. I thought about the different methods of steering those inattentive customers to buy fuel-efficient cars. Behavioral Tagging, screening, and nudging were interesting solutions for correcting these customers behaviors; but I wonder, how effective are they? In our culture, when a consumer wants something they feel entitled to have it and find ways to account for the extra expense. In another class we spoke about social institutions and governance that steer people to make choices. When these people make the wrong choices other community members chastise them. A student used an example from the Nicholas School. He pointed out that on every desk stood a re-usable water bottle. No one, in the school, dared to bring in a throwaway plastic one. While people feel entitled to do what they want, social pressures can be very effective.
I would agree that Pigouvian taxes are in appropriate because they don’t account for the market failure of inattention and misoptimization from consumers. From what I understood, this problem reverses the idea of a double dividend (revenue from correcting externalities allows government to cut other distortionary taxes). Therefore this problem will make the benefits fall short of the costs- there is no optimization. I would think CAFE standards would only exacerbate this situation. As I appreciate this point, I also agree that if any politician campaigned for taxing “inattentive” consumers she/he would be committing political suicide.
When I was in the market for a new car, I was very sensitive to the purchase price as well as any “add-ons” (I only had so much money to spend); and I did have an understanding of future energy costs. However, that didn’t stop me from wanting a larger car (did I call this entitlement, above? I meant strong willed consumers). Maybe if the larger cars had permanent yellow tags that had “gas-guzzler” or “polluter” I may have changed my mind.
My biggest concern with imposing a tax on gas-inefficient vehicles that target inattentive customers is with the equity issue, i.e. the difficulty with adequately segmenting the population between those who just love trucks/large cars and have the means to pay the higher taxes, and the blue-collar workers who may well need the car for their job but are penalized for it. On the other hand, nudge-inducing policies that tax the firm for their customers’ socially inefficient purchases seem relatively more feasible and equitable. The main advantage of this method is that it induces the car sellers to direct customers towards buying the more energy-efficient models rather than penalizing the customers themselves. This assumes that the car salesmen have to be trained to tout the energy-efficiency attributes of these cars rather than the other “sexier” features of the gas-guzzlers. However, I worry that firms will only be incentivized to nudge customers towards certain car models if the sellers can charge higher mark-up for those products. So the burden falls on the firm to do a stellar marketing job. If customers who would’ve bought a gas guzzler are unconvinced or don’t care about the energy-efficiency benefits of a more socially-optimal car, there is little incentive for these inattentive customers to buy the pricier, smaller, energy-efficient model. For this policy to work, firms would have to not only nudge customers towards the energy-efficient cars but also to revamp their entire marketing campaigns, work with car designers and partner with celebrities (as Stephanie Roe suggested above) to realign customers’ perceptions of owning an eco-friendly car. This requires a huge advertising budget that firms will likely not invest in unless there were specific incentives for the entire industry to do so. With the right incentives in place, it is in these car manufacturers interest to work with advertisers, celebrities and others to move in this direction – to ensure that energy-efficient cars become fashionable. If more of the cars sold are pricier, energy-efficient models, “inattentive” customers will be more inclined to buy these models (because it will be culturally fashionable to do so and also because thanks to advertising these customers would perceive these cars to have all the attributes they need). As for those customers who cannot afford the more expensive energy-efficient cars, they would continue buying the more affordable trucks and SUVs, because if these customers really need these cars it shouldn’t matter that these cars are no longer in vogue. This would not be a quick implementation by any means, and is probably flawed in many ways, but I do believe that addressing this issue from a systems perspective (instead of a pure taxation one) could be one way to segment out those customers who are inattentive from those who truly have no choice but to drive the gas-guzzlers.
I think people generally want to pay attention to the longer-term out-of-pocket cost of owning a vehicle, but car and truck dealers do a lousy job communicating that cost. They’re out to sell cars and trucks, after all. While I like the idea of taxing the inattentive, I think that targeting this group would be a huge challenge as the authors propose. Perhaps there are other ways? State property taxes? A mandated “it will cost you this much to operate this vehicle based on X amount of use” label rather than “buying this vehicle will save you X” label or no mention of ownership cost at all? Ultimately, people’s preference for large vehicles is a factor of many things, not just the cost. Safety is a big one, especially if kids are involved. You can’t put a realistic price on that. Another is utility. If a tax is going to be successful, it has to be large enough to outweigh these other factors. I don’t see this happening. I think out best bet is to focus on making these gas-guzzlers less thirsty, and in the meantime, increase property taxes on people who choose to buy large gas-guzzling vehicles for everyday personal use.
In a way, these taxes that “help” people make “better” decisions are already in effect: cigarettes, alcohol, and diamonds, for example, are taxed much more highly than food. And in some states, food and clothes are not taxed, because they are seen as necessities. What if taxes were raised on all cars with the consideration that they are not necessities, while only the most basic and efficient cars are sold tax-free? I know that raising taxes on cars is currently infeasible, but I think a change in our mindset may be the answer here. Instead of thinking in terms of “we’re from the government and we’re here to help” which makes tax payers think the governments is forcing them to make decisions, the tax structure should be based on necessities vs. luxuries. This way which people may not feel they are being told what to buy, but rather are made aware that they are buying a non-necessity and can therefore pay tax on it.