# Sales tax vs. VAT

An interesting paper by Chetty, Looney and Kroft (2008) looks at tax incidence with salience. What this means is that in standard economic theory the economic incidence (i.e. who will bear the tax burden) does not depend on whether a tax is levied on consumers or producers. Matter of fact, the only thing that determines economic incidence is the relative price elasticities of demand and supply.

However, a key assumption for this is that consumers always incorporate the tax into their decision-making. As the paper mentioned above shows, this may not always be the case.

As you learn in any intermediate micro course, in standard economic theory the change in price with respect to a tax is

$\frac{dp_s}{dt} = \frac{\epsilon_d}{\epsilon_s - \epsilon_d}$ for suppliers, and
$\frac{dp_d}{dt} = \frac{\epsilon_s}{\epsilon_s - \epsilon_d}$ for consumers.

Well, that’s if you believe that consumers behave optimally and they calculate with any taxes they might have to pay on a good that they’re about to buy; even if said tax is not salient (i.e. not clearly visible) at the time of making the purchase decision.

This means that the demand function for good x is the same when we have a price p and a tax tp as when we have a price equal to (1 + t)p but no tax:

$x(p, t) = x((1 + t)p, 0).$

This is logical. All it assumes is that the consumer is aware of the fact that there is a tax t on the good x and that she is capable of calculating (1 + t)p. A reasonable assumption indeed.

However, Chetty, Looney and Kroft show that when the tax is not included in the prices on the price tags in a store, then consumers forget about it even if they know it exists. Actually, in their experiment a 10% tax increase is needed to achieve the same effect a 3.5% price increase would.

In other words this means that

$x(p, t) > x((1 + t)p, 0),$

that is when the consumers know that the tax exists but the tax isn’t explicitly stated on the price tags, then demand will be higher than when the total tax-inclusive price is shown on the price tags (even though the actual price consumers pay is the same).

So how does this relate to sales taxes and VATs? Well, legally speaking I have no idea what the difference between these two taxes is, but that doesn’t matter. Because in the end what matters is economic incidence, not statutory incidence. And based on this research, it seems that there is a significant difference between the economic incidence of sales taxes and VATs.

VAT (value-added tax) is mostly used in Europe. It’s pretty much a tax that is universal across a country (e.g. it would be a federal tax in the US) and that is paid on goods and services. Most countries have several VAT categories: an example would be a regular VAT of 20%, a reduced VAT of 5% (on books and educational materials, museum tickets) and VAT-exempt goods such as food. When you buy something, you automatically pay the VAT. So far this is quite similar to a sales tax. But here’s the main difference: all the price tags in stores and in brochures and everywhere include VAT (possibly because it’s required by law). That is, the consumer doesn’t even need to know that the VAT exists in order to incorporate it in her decision-making.

As opposed to this, a sales tax is not included in price tags. Therefore, you may see that an item costs $2.00 in a store and then realize only at the cash register that you actually have to pay$2.00 x (1 + .07) = \$2.14 (if the sales tax is 7%).

So the main difference is that in case of a sales tax a consumer’s demand function would be x(p, t) whereas in case of a VAT it would be x((1 + t)p, 0), and as Chetty, Looney and Kroft shows the former is larger than the latter. What does this mean? It means that consumers are less sensitive to a sales tax increase than they are to a price increase, and that they are just as sensitive to a VAT increase as they are to a price increase. Consequently, a sales tax relative to a VAT

• puts more of the tax burden on consumers and less on producers,
• leads to higher consumption,
• leads to higher revenues for producers, and
• makes consumers behave less optimally.

Of course, there is no better one of these two tax types. One would have to take a look at all other taxes (and other policies) in a country to determine whether it is more advantegous to put more of the burden on consumers.

Also, notice that the main source of this difference is that retailers in the US are not required by law to include sales taxes in their advertised prices. So this could be changed by simple legislation (well, not so simple as sales taxes are set at the local/state level). Therefore, this effect does not arise from the technical differences between a sales tax and a VAT but from their practical implementation and regulation. This, however, does not change the practical differences that do exist between these two types of taxes and that have been detailed in this post.