Paul L. Caron

Friday, October 8, 2021

Weekly SSRN Tax Article Review And Roundup: Saito Reviews Seto’s Modeling The Welfare Effects Of Advertising

This week, Blaine Saito (Northeastern; Google Scholar) reviews a new work by Theodore P. Seto (Loyola-L.A.; Google Scholar), Modeling the Welfare Effects of Advertising: Preference-Shifting Deadweight Loss, 75 Tax L. Rev. ___ (2022).


Advertising is ubiquitous. Ads appear in almost every form of media from newspapers to television. Today, advertising is more powerful, with large tech companies using data collected on their users to create and sell targeted ads. The question for economics, and by extension tax policy, is do these advertisements influence our consumption patterns and how does that affect optimal tax theory. Ted Seto’s new piece, forthcoming in the Tax Law Review, Modeling the Welfare Effects of Advertising: Preference-Shifting Deadweight Loss reveals how the preference-shifting forces us to change our thinking about optimal tax theory.

Seto starts his piece critiquing on both a theoretical and common-sense basis most advertising. [1] Most ads reveal little pertinent information to the consumer. Furthermore, advertisements also do not provide information on the quality of the good or service either. Instead, most advertisements are earworms, jingles, and slogans.

But when people note these problems, standard economic theory, as Seto points out, ties itself in knots to explain why advertisements exist and how they could increase societal welfare. For example, some economists say advertising is a complement to consumption. If one consumes more advertising then someone will consume more goods, much like when people buy more butter, they tend to buy more jam. But the complement breaks down, because in the butter and jam example, people who buy more jam tend to buy more butter, but it would be strange to say that those who buy BMWs consume more BMW ads. A second theory is even more strained. When one sees advertising, one gets some intellectual capital that creates imputed income. Thus, paying more for an item that was advertised is the payment not for the good’s value to the consumer, but the value of the good plus the imputed income from the intellectual capital. Seto points out how absurd that theory is both on its own terms and under a practical common-sense understanding.

Seto then goes to some of the recent empirical work that shows that advertising can induce what seem to be non-value creating preference-shifting. He cites two studies, the first looked at advertising in loans. Here, the study found that a photo of an appealing woman posted in the loan ad induced people to pay, on average, 25% more in interest on a loan than if the picture were not there. The second study involved advertisements for a prescription drug with little efficacy difference from a nearly chemically similar prescription drug that went off-patent and thus had a generic substitute. Here, the advertisement induced people to pay upwards of 900% more for a drug that had at best marginal improvements on the generic drug. Both studies imply that there is some preference-shifting induced by the advertisements that are away from the welfare maximizing outcome. Seto calls for greater empirical research to see more of these effects and to determine the exact mechanism as to how these preference-shifts occur and their relation to overall social welfare.

Drawing from the implied results though of these two studies, Seto outlines how a preference-shift can lead toward societal costs. As many a tax scholar understands we have upward sloping supply curves and downward sloping demand curves with an equilibrium at the intersection. When we have preference-shifting, the demand curve shifts upward, resulting in a new equilibrium point that has a greater consumption of the good. But this move away from the societally optimal equilibrium creates a wedge of deadweight loss. This wedge of deadweight loss is the flip to the wedge of deadweight loss created when a tax is imposed and reduces the quantity of goods consumed in a market from the welfare maximizing level. Thus, if we have preference-shifting there is an overall decrease in societal welfare according to standard economic theory.

The paper then concludes with two key points for tax policy. First, taxes on goods that are advertised to the public may be efficient. The idea is that such a tax would rejigger the system. While the preference-shifting from advertisements shifts the demand curve upward, this tax would simply undo this outcome, shifting the demand curve back down to the welfare maximizing equilibrium point.

The second implication is related to income taxation. Instead of trying to figure out commodities are advertised and taxing those commodities, a progressive income tax could do rough justice to undo the distortive effects of advertising induced preference-shifting. Seto notes that increased income is likely correlated with greater welfare destroying preference-shifting from advertising. As people earn more, they have more to spend on non-essential items, and those are the very items that are most susceptible to preference-shifting. Thus, contrary to the standard view, the progressive income tax actually removes distortions rather than creates them.

Seto’s piece does two things. While it reads as if it is a work on an optimal tax theory and law and economics, it actually reveals how the key assumptions there are problematic. In doing so, it provides an excellent critique of that worldview. Indeed, Seto himself points out that societal welfare itself is poorly defined by those in the economics field. Seto thus pushes us to think more deeply about something that economics cannot answer, and a lot of tax discussions avoid. Those questions are: What are our societal values? How do we create a tax system that reflects those values?

Additionally, Seto’s piece also challenges us to think about the corrosive effect of our consumerist culture. The piece implies that all this consumption of goods and induced demand is not necessarily creating value for society. It may be making us worse off. It at least forces me to think too, not only about tax policy, but my own habits in this world. Perhaps I should seek more simplicity and avoid the draws of advertising that turns wants into needs. And perhaps too, Seto’s piece serves to us not only as an important contribution to taxation, but as a wake-up call to all of us about how consumerism may undermine our pursuit of our happiness.

[1] I should note that I appreciate Seto’s dry humor throughout the piece and consider it a strength.

Here’s the rest of this week’s SSRN Tax Roundup:

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