Studying a Sin Tax Scheme with Multiple Reforms: Lessons for Consumption Taxation

Abstract

Consumption taxes are important sources of tax revenue, and they also have a corrective role. Demand elasticity is one of the key concepts for how effectively consumption taxes meet their policy goals. This paper studies the relationship between substitutability of taxed and non-taxed goods and the demand elasticity. We organize the paper through a simple model that yields as a result a highly convex relationship between the demand elasticity and how close non-taxed substitutes are available. Empirically we analyze a Finnish sin tax scheme for sweets, soda and ice cream providing us with quasi-experimental variation through multiple reforms. We have unique product-level data on sales and prices containing hundreds of millions of observations. We also develop survey evidence on substitution preferences across categories of goods. Our estimated consumption elasticity is close to zero for sweets and ice cream that have intermediate non-taxed substitute: cookies. In a stark contrast, when the tax rate was doubled for sugary soda but not for their close substitute non-sugary soda, consumption elasticity is close to unity. These estimates align well with our theory framework wherein even with intermediate non-taxed substitutes available the demand elasticity is close to zero, while it is close to unity when very close substitutes are available. We also provide evidence that the quasi-experimental price elasticity estimates in the previous literature align with our theory framework. Joint paper with Sami Jysmä and Riikka Savolainen.