Some Implications of Preference-Shifting for Optimal Tax Theory Theodore P. Seto Loyola Law School, Los Angeles

Introduction Standard model assumes that preferences reflect welfare Preference-shifting: where demand for a good is shifted upward without any increase in the welfare consumers obtain by reason of purchases of that good Claim1: A tax less than or equal to the amount of a good’s preference-shift (1) will not result in any tax deadweight loss (Harberger 1964), and (2) will reduce preference-shifting deadweight loss. Such a tax will increase aggregate welfare Claim 2: A portion of the tax equal to preference-shifting deadweight loss will be recovered through elimination of that loss and will not be borne by any taxpayer

Part I: Preference-Shifting

Bertrand 2010: What’s Advertising Worth? Field test of effect of advertising on demand Product: small, high-interest, short-term, uncollateralized loans with fixed monthly repayment schedules targeted to a working poor population in South Africa Sample: direct mail solicitations to 53,194 former clients offering each a new loan, at randomly assigned interest rates, with randomly assigned deadlines for taking up the offer and randomly assigned variations on eight advertising content “features” Dependent variable: loan application rates Finding: males were willing to pay 316 basis points more for loan if received ad with picture of woman

Ad with picture of woman

Limitations of Bertrand study Single-shot advertisement, one page of written material Intermediate product (product used to purchase other products), so hard to argue 316 basis point of welfare benefits from added demand Long-term repeated advertising would be expected to have larger impact, but most products are not intermediate Paper gives example of one highly advertised end-use product (Nexium) with over 500% price premium over medically equivalent alternatives

Part II: Tax Deadweight Loss

Figure 1: Standard model of surplus

Figure 10: Flat commodity tax nominally imposed on consumers

Part III: Modeling Preference-Shifting

Figure 2: Modeling preference-shifting

Figure 3: Preference-shifting deadweight loss

Figure 4: Producer gains

Figure 5: Consumer gains/losses

Figure 6: Net social gains/losses

Figure 7: Example: net social loss

Figure 8: Preference-shifting summary

Figure 9: Combination case

Part IV: Tax Deadweight Loss with Preference-Shifting

Figure 11: Standard model of tax deadweight loss

Figure 12: Tax on preference-shifted good

Part V: Incidence of the Tax

Figure 13: Effect of tax on producers

Figure 14: Effect of tax on consumers

Conclusions and Further Work Part V: Conclusions and Further Work

Conclusions Imposition of a flat commodity tax at a rate less than or equal to the preference-shift increases aggregate social welfare If such a tax is imposed in an amount equal to the preference- shift, producers will bear the burden of the tax to the extent of their pre-tax preference-shifting profits Consumers will bear the burden of such a tax to the extent such burden is not borne by producers, but will also benefit from the elimination of preference-shifting deadweight loss A portion of the tax equal to the preference-shifting deadweight loss will be recovered through elimination of that loss and will not be borne by any taxpayer.

Possible Implementation Limit retail sales and value added tax exemptions to non- advertised goods. Required assumption: that, in general, preference-shifting by reason of advertising equals or exceeds the retails sale or value added tax rate Since such rates are normally small relative to price, such an assumption is plausible

Extension to income taxation If preference-shifting operates differently on different commodities in random way, cannot generalize to income taxation (e.g., need to set commodity taxes at different rates to offset different amounts of preference-shifting) But if taxpayers purchase essentials first and preference- shifting operates primarily on non-essentials, may be able to generalize to income taxation To this extent, progressive income taxation may increase aggregate welfare by reducing preference-shifting deadweight loss while not generating tax deadweight loss

How to measure welfare: Happiness? Assumption: Steady-state happiness may measure objective welfare (that is, body knows what it needs, even if mind can be misled) Procedure: Estimate expenditures (≈ income) that produce increase in happiness and therefore increase objective welfare Identify point past which increased expenditures do not produce increased happiness and therefore do not increase objective welfare