(Ir)Rational Consumer Responses: Effect of Uncertain Tax Changes

Abstract

In this paper, we employ a unique tax experiment and dataset in a highly salient tax rate environment to examine consumer response to complex and uncertain tax reforms. Tax reforms raise some fundamental questions in public finance: How does consumption respond to tax change? How is the tax burden distributed among the stakeholders? More importantly, are these answers conditional on whether the tax regime (and not the tax rate) is salient? We find that unpredictability of tax policy changes induces imperfectly rational consumption response. The tax regime complexity does not allow clear tracing of price change despite full information about tax rate changes and so, consumers also respond to notional price changes. This notional response is based on inaccurate beliefs about the impact of visible tax changes on real commodity prices and thus, consumers hoard even those goods that experience a price fall post reform. We further analyse commodity pricing to see how businesses respond and provide evidence of skewness in pricing response post the reform. The burden of tax increase is passed through more than the benefit of tax decrease. Both these aspects, irrational hoarding and an asymmetric transfer of tax benefit to final consumers, are welfare reducing. This is important from a policy perspective since it highlights issues created by complex tax policies.