What makes for a “good” tax? From the point of view of government policymakers, a good tax raises a lot of money without causing people to avoid the tax by distorting their spending (or voting) behavior.
By that measure, a sales tax is a very good tax indeed: a body of research shows that, overall, sales-tax rates are not noticeable enough to consumers to make them change their behavior. In other words, we tend to adopt an attitude of “it is what it is” about sales tax—even when the rates go up—and just get on with the business of purchasing what we need.
But most of what we understand about how people respond to sales taxes comes from observing national consumer spending in aggregate and looking at changes on an annual basis. New research from the Kellogg school explores whether individual households are really so blasé about the government-mandated markups at the cash register.
“You know, we're Americans—we don't like paying taxes,” quips assistant finance professor Scott Baker.
Baker, along with assistant finance professor Lorenz Kueng and Stephanie Johnson, a graduate student at Northwestern University’s department of economics, wanted to put consumers’ responses to sales-tax changes, “under a microscope,” as Kueng puts it.
"It's only when you're able to zoom in on an actual month that you can actually see a very clear, very stark pattern of change in the way individual households spend their money.” —Scott Baker
Using data from the Nielsen Consumer Panel and Thomson Reuters, the researchers assembled a month-by-month timeline of consumer-spending choices from more than 150,000 households across the U.S. The database included purchases at grocery, pharmacy, and mass-merchandise stores, averaging about $350 per month per household. The researchers then matched the data against changes to local sales-tax rates in 41,250 ZIP codes between 2008 and 2014.
“We could measure very precisely what tax rates these households were subject to and when,” Baker says. Additionally, “you can tell if they bought the 20-ounce bottle of Coke or the two-liter bottle.”
This highly specific data matters because some products are tax-exempt in certain ZIP codes, while others are not. For example, most grocery items are exempt from local sales tax, while toys and tools are almost always taxed; clothing or prepared food, meanwhile, may or may not be subject to sales tax depending on where it is purchased.
The authors compiled additional data to examine what they call “the fiscal implementation lag”: the time between when the public learns about an upcoming sales-tax increase and when it actually is implemented.
To measure this lag, the authors scoured 3,000 U.S. newspapers from 2008 and 2016 for mentions of “sales tax” or “sales taxes,” analyzed Google search data to measure the frequency of relevant search terms like “sales tax,” and identified state-ballot items that proposed a change to local tax policy.
When all the numbers were crunched, it turned out that traditional wisdom on the impact of sales-tax rates held—but only when looking long term.
The researchers saw no impact on household spending habits four months to a year after a sales-tax increase. But when they focused their “microscope” down to the month immediately before the change, as well as the month immediately after, they found that “all this anticipatory action occurs,” Baker says. “It's only when you're able to zoom in on an actual month that you can actually see a very clear, very stark pattern of change in the way individual households spend their money.”
Shifting Costs to Avoid Sales Taxes
The clearest impact that the researchers observed will sound familiar to anyone who has changed their shopping plans to take advantage of a sale.
“Households in the month before the tax increase tend to stock up,” Kueng says. “And then there’s a kind of a mirror image decline in consumption in the following month” when the increased sales tax comes into effect.
“This seems to be most consistent,” he says, “with a story that they were time-shifting their purchases”—that is, buying next month’s goods ahead of time to avoid the tax.
Other findings made intuitive sense, as well.
For example, the “stocking up” effect on consumption was four times greater when the authors focused their analysis on nonperishable goods. “There's much more of an effect if you're looking at T-shirts, small electronics, laundry detergent—anything durable or easily storable,” Kueng says.
Crossing state lines to avoid sales taxes also increased among households located in ZIP codes where such movement is physically convenient.
“If you live in a part of Chicago that's near Wisconsin or near Indiana, you might shift across the border if there are lower sales taxes there,” Kueng says.
Online shopping spiked upwards following a local increase in sales tax, too, likely because few consumers pay the additional sales tax, called a “use tax,” that they are supposed to pay on goods bought out of state at a lower sales-tax rate, Baker says.
Taking pains to avoid paying a few extra cents of sales tax might sound pointlessly frugal, but it struck Baker and Kueng as eminently reasonable behavior for the average price-sensitive, tax-phobic American household.
“The effect isn’t huge,” Kueng says. “But if you compare it to how people respond to ordinary price changes or store sales, it’s in the same ballpark. It’s definitely not crazy.”
A Surprising Effect of a Sales-Tax Increase
One result, however, caught the researchers by surprise.
They found that during the “stocking up” phase in the month before a sales-tax increase, households did not just buy more taxable goods—they stocked up on tax-exempt items, too.
This seemed irrational: Why would consumers bother to do this time-shifting for goods whose cost will not change over time?
“That was probably the most surprising result that we found,” Kueng says.
One potential explanation: consumers simply don’t know any better. “The idea is that they are just confused—they don't know which goods are tax-exempt and which goods are taxable,” Kueng says.
But the researchers wondered if, instead, this seemingly irrational spending behavior might actually be an optimal response to the practical realities of shopping.
“The only reason a ‘shopping trip’ actually exists is because it's kind of costly to go to the store under any circumstances: you have to get in your car, use gasoline, wait in lines, all that stuff,” Baker explains. “And so if you’re already out there getting extra things that you know will be more expensive a month from now, you might as well pick up a few other things that you might be close to running out of too, even if they’re not going to be affected by the sales tax. It’s still less costly than making a separate trip later.”
In other words, households may know the difference between taxable and tax-exempt goods—they just know that shopping trips are a pain, too. And so stocking up on both categories of items at once in order to keep those costly trips to a minimum might be rational economic behavior after all.
Under this theory, it follows that shopping trips with no fixed costs—like buying goods online instead of in a store—would not show the same kind of “stocking up” effect for taxable and tax-exempt items at the same time.
“And that is exactly what we found,” Kueng says.
Is It a Good Tax?
So if individual households notice and respond to the sales tax in the month before and after a rate change, does that mean it’s a “good” tax—or not?
“If you don’t want taxes distorting how people spend, it appears that in the short run, sales tax is distortionary,” Baker says. “But that may also be a desirable policy outcome.”
He cites the Cash for Clunkers program in the U.S.—in which consumers were given vouchers for trading in aging vehicles, which could be applied to lower the cost of purchasing a newer, more fuel-efficient vehicle—as an example of this “desirable distortion.” The program provided a cash infusion into the auto industry by shifting car purchases forward in time, while also getting some inefficient vehicles off the road.
Intentional time-shifting of purchases could even function “as a kind of stimulus package,” Baker adds. “For groceries and pharmacy items, we find that the effect is relatively short-lived on average. But the more storable and durable the product, the longer the effect of a sales-tax change on the economy. For larger durables like furniture or cars, we would expect even larger effects that would last for a couple of quarters or years.”
And, when zooming the microscope back out, Baker says, “the tax is also good in the sense that, in the longer run, it doesn't seem to be very distortionary.”