Optimal Tax Salience

Abstract

Recent empirical work suggests that consumers systematically misperceive commod-ity taxes when the after-tax price is not prominent. I show how policymakers may utilize such low-salience taxes to enhance consumer welfare. The optimal combination of high-and low-salience taxes balances two competing welfare effects: low-salience taxes accommodate lower tax rates but induce consumers to misallocate their budgets. The efficiency gains from implementing the optimal policy are substantial, up to the entire deadweight loss from distortionary taxation. The surprising result that the optimal policy is to induce taxpayer mistakes can be readily understood as an application of the theory of the second-best.