Mind the Crossover! The Effects of Notches in Vehicle CO2 Taxation on Manufacturer and Consumer Behaviour

Abstract: Tax notches – discontinuities in tax schedules implying that marginal behavioural changes result in discrete changes in tax liability – are widely used in fiscal and environmental policy. We analyse the impact of tax policies using notched schedules of vehicle CO2 emissions in the Netherlands on the behaviour of manufacturers and consumers, and on welfare. Our empirical approach exploits variation in CO2-emissions’ cut-off values determining a car’s eligibility for preferential tax treatment in the period 2010-2014. We find that not only do notches drive changes in consumer demand, but also induce manipulative responses from car manufacturers. Automakers firmly respond to increasing policy stringency over time by reducing official emission levels of specific models just below the new cut-offs, without fundamentally changing them – car weight remains intact. Manufacturers’ response is particularly strong for diesel cars, which are popular in the company car market. The welfare losses from inefficient production due to notched company car taxation are non-negligible. Switching from notched to smooth vehicle CO2 taxes improves the environmental effectiveness and economic efficiency of the policy. Co-author: Jos van Ommeren (Vrije Universiteit Amsterdam).