A Level-headed Discussion about Passing along the Consumption Tax

TSURU Kotaro
Program Director and Faculty Fellow, RIETI

Over a month has passed since the April rise in the consumption tax rate. Looking at the various studies, it appears that the increase is being passed along smoothly to prices, and that the much feared reduction in demand in response to the tax hike seems smaller than predicted. However, it is undeniable that the discussion so far has concentrated too much on whether the entire increase would be passed along to prices and if the responding reduction in demand and deflationary effects would occur after the increase. This column focuses on businesses' pricing strategies in response to the increased consumption tax and considers the policy implications of such strategies.

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A key point to which we should pay attention in terms of the recent tax rate increase is the change in the way businesses display their prices as a result of a special measure. Beginning in FY2004, the law required businesses to display the entire price, i.e., the price of the product itself plus the consumption tax. However, for a limited time (through March 31, 2017), businesses now are allowed to display the price before taxes. As a condition, they must take steps to prevent confusing their customers.

The purpose was to lighten the burden on businesses, such as by eliminating the need to change price tags again, since another rate increase, this time to 10%, looms in October 2015. However, prices displayed on price tags actually may seem cheaper now to consumers because the pre-tax prices are shown, and consumers have grown accustomed to seeing the tax-inclusive total prices.

If consumers are rational, of course, they will correctly understand the cost that they bear, whatever that is shown on the price tag, and this special measure will not affect consumer behavior. Recent research, however, clearly shows that tax labeling does change consumer behavior.

A 2009 paper by Harvard University Professor Raj Chetty et al. studied if American consumer behavior changes based on whether store price tags show the tax-inclusive price or the pre-tax price. Whereas price tags in Europe include the value-added tax, retail taxes in the United States are implemented at the state level and usually are not included in the price tag. In an experiment, some supermarket products were labeled with the ordinary pre-tax price and others with the tax-inclusive price. Sales of the latter dropped by 8% on average.

Beer, however, is subject not only to retail tax, but also an excise tax on alcohol at the state level. In stores, the excise tax is included in the displayed price, which does not include the retail tax. Chetty et al. used the fact that retail taxes and excise taxes are at different rates and undergo different changes in each state. They found that increasing the excise tax did more to lower beer consumption than did increasing the retail tax. They suggested that consumers are under an "illusion" that makes their cost seem smaller if the price tag does not directly reflect a tax.

Cornell University Assistant Professor Tatiana Homonoff et al. conducted a similar analysis on tobacco products in a 2013 paper. Stores display the pre-tax price of tobacco i.e., without the retail tax, but include the excise tax on tobacco in the pre-tax price, as they do with beer and some other products. In this case, the authors looked at differences between high-income and low-income consumers. Both groups reacted to changes in the excise tax, but only low-income consumers reacted to changes in the retail tax. This indicates that low-income consumers are sensitive to changes in total price, regardless of tax labeling.

Therefore, it is possible that price tags with pre-tax prices will interfere with optimal consumer behavior based on price, in spite of measures to prevent confusion. Japan should reaffirm that the conventional practice of labeling price tags with the total price is still preferable.

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One point to keep in mind about the recent tax increase is that the way the increase is passed along to the price differs by product.

Considering the real market environment (where competition is imperfect), the pass-along will differ based on whether demand changes with price and other factors such as market structure. Both theory and empirical analysis tell us that the optimal price increase will be higher at times and at other times lower than the change in the tax rate.

Let's take two theoretical products, A and B, with a cost price of 0. A retailer sells 200 of each at a unit price of 100 yen. For every 1-yen price increase, the retailer sells two units less of A and 0.5 units less of B. If a 10% consumption tax is imposed and the retailer adds the entire amount to the price, it will sell 180 units of A and 195 units of B. But if the retailer leaves the tax-inclusive price at 100 yen, sales will stay the same. The retailer's profitability will decrease by 1,300 yen for B but increase by 200 yen for A, compared to passing along the tax to the price (see Figure).

Figure: Best price pass-along strategy will differ by product Figure: Best price pass-along strategy will differ by product
Note: The cost price is assumed to be 0.

Thus, for a business seeking to maximize profitability, taking sales volume and cost into account, it is not unusual for the pass-along rate to differ by product. Therefore, it is short-sighted to assume that the inability to pass along 100% of a tax increase is necessarily to the business's detriment, or that raising prices even more than the tax increase is price-gouging. In North America and Europe also, government officials purportedly tend to assume that the pass-along rate should be the same for all products and that the entire tax increase should be passed along (consumers should bear the entire increase). It is surprisingly difficult for people to understand these matters correctly.

What is especially interesting is that there are some products in Japan for which the tax-inclusive price itself has gone down since April. McDonald's Japan, for example, lowered the price of some of its products. The tax-inclusive price of a hamburger fell to 100 yen, a drop of 20 yen. The beef bowl chain Sukiya lowered the price of its regular-size beef bowl by 10 yen to 270 yen. Such items are among the lowest-priced products offered by those businesses, and any price drop seems likely to give a big boost to demand (i.e., those products are highly elastic). In cases like this, it is a rational price discrimination strategy to keep pass-along low and then, in addition, lower prices if the consumption tax increase causes overall demand to fall.

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While there are some products with falling prices, there are also products with price increases exceeding the increase in consumption tax. In part, this may be the impact of a product's unique characteristics, as mentioned above. However, it also could be understood that an increase in the consumption tax rate softens price rigidity and creates an opportunity to eliminate deflation from the economy. This mechanism was described in the April 18, 2014 "Keizai Kyoshitsu" column by Professor Tsutomu Watanabe of the University of Tokyo.

Price rigidity means that prices do not change very quickly, even if costs change. This limits how often prices can be amended. Menu costs, or the cost of the physical burden of, for example, changing price tags, are often mentioned as the cause of price rigidity. In fact, however, coordination failure likely has a greater impact. Coordination failure means that a business cannot raise its own prices unless its competitors do as well.

New York University Professor Luis Cabral et al. analyzed this point in a 2012 paper. Their analysis was based on search cost, i.e., the cost to consumers of obtaining price information. Consumers pay a cost to research the most inexpensive product. In light of this, consumers will not research prices as long as sellers' prices do not change. However, if a seller raises its price, customers will notice that the costs have changed and will start researching prices, and ultimately they will buy from a rival of the original seller. Cabral et al. stressed that such a construct is behind "sticky" prices—prices that resist rises.

In consideration of this, we can see increases in the consumption tax as opportunities for businesses that may have wanted to pass along their costs previously but were unable to do so. European Central Bank research also shows that in many European countries, prices are amended more frequently before and after changes in the value-added tax rate, which softens price rigidity.

As the Japanese population rapidly ages, ensuring the sustainability of the nation's social security and finances will require a readiness in the future to raise the consumption tax rate to nearly 20%, about the same as in Europe. Instead of arguing whether consumers or businesses should bear the cost of the consumption tax, it would be more helpful to contemplate how to increase the productivity of every Japanese citizen. If that were to happen, businesses would be able to keep price increases in check and citizens could increase their incomes, which would absorb the burden. Fiscal soundness likewise depends ultimately on how we can increase individual productivity.

>> Original text in Japanese

* Translated by RIETI.

May 19, 2014 Nihon Keizai Shimbun

June 10, 2014

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