Taxing the Sweet Tooth - Evidence on the Role of Substitution in Excess Burden

Lecture given by Tuomas Kosonen, Research Professor with the  VATT Institute for Economic Research in Helsinki.

Excise taxes are effective means to meet policy goals when they succeed in reducing consumption of the targeted goods, while VAT and sales taxes are efficient taxes when they create as few behavioral responses as possible. To provide novel answers to the question of when these conditions are met, we propose a conceptual Gorman-Lancaster theoretical framework focusing on how different product characteristics relate to substitution patterns between consumption of goods and the demand elasticities. Empirically, we study a Finnish sweets and soda tax scheme providing us with quasi-experimental variation in excise taxes on sweets, soda and ice cream. Importantly, the reforms create variation in how close substitutes the non-taxed goods are to the taxed ones, allowing us to link the empirical results with our theoretical framework. We have unique product- and week-level data on sales and prices containing hundreds of millions of observations. We also have survey evidence on substitution preferences across goods. The quasi-experimental results indicate that even when taxed and non-taxed goods are relatively close subsitutes, the demand elasticity is zero. Only with very close subsitutes, such as sugary and non-sugary soda, we estimate a high demand elasticity. These results match our analytical result when matched with the substitution index from the survey.