Behavioral optimization of US air travel taxes

Abstract

Recent literature has documented consumers’ imperfect optimization when facing taxes. Despite the rich literature in this area, little research has been conducted in the airline industry context. I exploit the variation of tax changes in the airline industry to analyze how US passengers react to tax and price changes. I show that passengers react more strongly to taxes than to price changes through the use of semi-elasticities. Baseline estimates suggest that the tax elasticity of demand is approximately 1.5 times as strong as the price elasticity of demand. This paper extends the literature by allowing for heterogeneous price and tax responses, and by providing a series of possible rationales that explain how overoptimization can arise in the airline industry. Tax aversion, media coverage, persistent tax increases, psychological factors, and non-standard preferences suggested in the literature could all contribute to explaining passengers’ overoptimization in the airline industry. The findings in this paper have profound contributions both to the economic literature, to the airline industry, and practitioners at both the local and federal levels.