Carrots, Sticks, and Salience

Abstract

This Article considers the second-best design of Pigouvian taxes and subsidies in the presence of agents who are imperfectly aware of the instrument. Until very recently, the price instrument literature has assumed perfect rationality, and even the handful of prior attempts to account for “hidden” prices focus mainly on the income tax. I extend these efforts in several directions. First, I show that the best available instrument for correcting negative externalities is often one whose price is partially adjusted upwards -- or, in the case of subsidies, downwards -- to counter-act the neglect of irrational actors. In addition, I argue that the salience of a price instrument can affect the choice between sticks and carrots, potentially making carrots a more viable option than is usually claimed in existing literature. I also address the cases of positive externalities, “hyper-salient” actors who are excessively attentive to price instruments, and combinations of each. Finally, I highlight evidence suggesting that the problem of imperfect awareness of price instruments is likely inevitable and widespread, implying that even if government does not intentionally set out to manipulate public awareness of its policies, salience will typically be an important factor in policy design.