psychological taxing in flemish municipalities

Journal of Economic Psychology 24 (2003) 741–762

www.elsevier.com/locate/joep

Psychological taxing in Flemish municipalities

John Ashworth a, Bruno Heyndels b,*, Carine Smolders c

a Department of Economics, University of Durham, 23-6 Old Elvet, Durham DH1 3HY, UKb Vrije Universiteit Brussel, Pleinlaan 2, B-1050 Brussels, Belgium

c Hogeschool Gent, Department Handelswetenschappen en Bestuurskunde,

Voskenslaan 270, B-9000 Gent, Belgium

Received 25 April 2002; received in revised form 27 July 2002; accepted 27 June 2003

Abstract

We analyse whether the psychological pricing in the private sector has a public sector coun-

terpart in tax policy. Analysing the main theoretical arguments for the existence of price

points, and applying them to the public sector, suggests that psychological taxing reveals itself

by the use of non-0 ending tax rates. The tax rate endings of the local income taxes, which are

set by 308 Flemish municipalities in the fiscal year 1998, suggests the presence of psychological

taxing. Non-0 endings occur more frequently in municipalities where demand for public policy

is more elastic (and where, therefore, the benefits to the politicians from setting a tax just be-

low a tax point is higher). The pre-tax income inequality and the level of the tax rate positively

affect psychological taxing. The latter effect is reinforced in those municipalities where the ex-

isting tax rate is above the average tax rate in neighbouring municipalities and below their

neighbours’ minimum, although this effect has a limited effect and is offset the further below

the minimum the tax is set.

� 2003 Elsevier B.V. All rights reserved.

PsycINFO classification: 2340; 2960

JEL classification: D78; H29

Keywords: Local taxation; Rightmost digit perception; Multiple regression

* Corresponding author. Tel.: +32-2-629-21-17.

E-mail addresses: [email protected] (J. Ashworth), [email protected] (B. Heyn-

dels), [email protected] (C. Smolders).

0167-4870/$ - see front matter � 2003 Elsevier B.V. All rights reserved.

doi:10.1016/j.joep.2003.06.002

mail to: [email protected]

742 J. Ashworth et al. / Journal of Economic Psychology 24 (2003) 741–762

1. Introduction

Tiebout (1956) and Hirschman (1970) introduced into the fiscal federalism litera-

ture the notion that there are important similarities between the public and the pri-

vate sector. The choice problems for consumers and producers in the market placeare not too different from the problems which voters and politicians face in a setting

of (local) governments. As a consequence, one can expect behavioural similarities to

be observed in both settings.

A stylised fact in consumer research is that consumers use a reference price to

evaluate the purchase price of a product (for a comparative analysis of reference

price models, see Briesch, Krishnamurthi, Muzumdar, & Raj, 1997). Past prices

of a product or current prices of competing brands are used as a point of refer-

ence. Often, the reference point effects in consumer research are hardly compatiblewith the model of economic rationality, which typically serves as a starting point

for the positive analysis of government. 1 Therefore, it should not come as a sur-

prise that these effects have only received scant attention in the fiscal federalism

literature so far (though there are exceptions; see Ashworth & Heyndels, 2000a,

2000b).

In the private sector, one of the alleged consequences of the use of reference points

is the intriguing and well-established practice of using ‘‘just below’’, ‘‘odd’’ or ‘‘psy-

chological’’ pricing. In the most general sense, this refers to the practice of price-set-ters exploiting discontinuities in the demand curve which occur at so-called price

points. The empirical implication of psychological pricing is, then, that certain digits

are more likely than others to appear as the rightmost (see Schindler, 1991) digit of

an advertised price.

To the extent that taxes are the public sector’s counterpart of private sector prices,

one could expect the occurrence of ‘‘psychological taxing’’; leading to non-evenly

distributed tax rate endings. The present article investigates whether such psycholog-

ical taxing indeed occurs and tries to identify its determinants. Thereto we analysethe tax rates for the local income tax set by all 308 Flemish municipalities (Section

2). Section 3 reviews the marketing and consumer behaviour literature on psycholog-

ical pricing and considers the relation with psychological taxing. We find a theoret-

ical agreement on the fact that psychological taxing lowers the probability that tax

rates have a 0-ending. In Section 4, we present seven hypotheses on what determines

the use of positive (non-0) rightmost digits in local income tax rates. These hypoth-

eses are empirically tested in Section 5 for the local income tax rates set in 1998. A

discussion and conclusion are in Section 6.

1 An interesting exception is the recent literature on political yardstick competition. There, the notion of

reference points is explicitly embedded in a rational framework. For example, in Besley and Case (1995)

voters use neighbouring jurisdictions’ policies as a yardstick – a point of reference – in order to evaluate

their own incumbent at election time. This comparison is a rational response of the voters to overcome the

informational asymmetry with respect to politicians’ ‘‘quality’’.

J. Ashworth et al. / Journal of Economic Psychology 24 (2003) 741–762 743

2. Tax rate endings in Flemish municipalities

Flemish municipalities have considerable discretion to pursue their own tax pol-

icies. Taxes account for about 40% of current revenues. Municipalities are allowed to

introduce new taxes within very broad limits. This has led to a situation where, to-day, the average municipality raises up to 20 different taxes, and some municipalities

collect revenues from no less than 50 tax sources. Still, most of the taxes are small in

terms of the revenue raised. About 80% of municipal tax revenues are raised through

only two taxes: the local property tax and the local income tax. Both taxes – which

are broadly of equal importance – are surcharges. The former is calculated as a per-

centage of the regional property tax. The latter is based on the federal income tax. It

is this tax that we concentrate on in what follows. The municipal surcharge is a flat

rate, which is calculated on a highly progressive federal income tax. As such, the mu-nicipal tax ‘‘copies’’ the federal progressivity.

Municipalities are free to set their local income tax rate at any level (including

zero). Actual rates in 1998 range from 0.0% to 9.0%. A formal constraint is that

the tax rate can only have one decimal digit. This constraint was imposed from

1987 onwards. Before that, municipalities could only have integer tax rates. Our

analysis relates to the use of rightmost (decimal) digits in the local income tax rates

for 1998. Fig. 1 gives the number of municipalities (out of 308) that used a positive

rightmost digit (a non-0 ending tax rate) over the period 1986–1998. As can be seen,the number of municipalities choosing a positive rightmost digit has increased sys-

tematically over the period. By 1998, 82 out of 308 (26.6%) municipalities use a

tax rate that does not end in 0.

The more frequent use of positive rightmost digits has not led to a uniform distri-

bution of the positive tax rate endings. This is clearly illustrated in Table 1 which

gives the frequency for all rightmost digits in 1998. Apart from the remaining dom-

inance of 0-endings, Table 1 reveals an overrepresentation of 5-endings. From all

municipalities using a tax rate with positive rightmost digit, 70% (58 municipalities)had a 5-ending tax rate. A second striking characteristic of the distribution of tax

0102030405060708090

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

number non-0 endings

Fig. 1. Municipalities with non-0 ending tax rate.

Table 1

Rightmost digits in Flemish local income tax 1998

Rightmost digit 1 2 3 4 5 6 7 8 9 0

Observation 0 3 2 1 58 3 3 10 2 226


rate endings is its asymmetry: whereas only six municipalities had a tax rate ending

between 1 and 4, the number of municipalities with a tax rate ending between 6 and 9

is three times as large. Finally, Table 1 reveals that 1-endings are used nowhere and –

strikingly – that there is a pronounced dominance of 8-endings. From the 24 munic-

ipalities using a tax rate ending which differs from 0 or 5, no less than 10 have a tax

rate ending in 8. It should be noted that these general observations are in no sense

just a quirk for 1998 or solely for Flemish municipalities. The same pattern occurs

in previous years and in Walloon municipalities, which work in an identical institu-tional setting (and are only excluded from our analysis due to the unavailability of

data necessary for the later empirical analysis).

Given the presence of a non-uniform distribution of tax rate endings, the question

arises to what extent the pattern in Table 1 corresponds with the patterns observed in

the private sector. In the private sector non-uniformly distributed price endings are

often observed (Dalrymple & Haines, 1970; Friedman, 1967; Kashyap, 1995; Schind-

ler & Kirby, 1997; Twedt, 1965; Wedel & Leeflang, 1998). A common finding in this

literature is that ‘‘9-ending prices’’ occur most frequently (Friedman, 1967; Schindler& Kirby, 1997; Twedt, 1965; Wedel & Leeflang, 1998). Such an observation can

clearly not be made with respect to Flemish tax rate endings. If anything, we might

speak about a (modest) 8-ending effect in the public sector. We do, however, find a

stronger correspondence with the other findings on private pricing. In both the pri-

vate and the public sector, 5-endings occur often. With respect to the 0-endings, the

Belgian tax rates show most resemblance with the results in Schindler and Kirby

(1997) whom, in contrast to Twedt (1965) and Friedman (1967), found that these oc-

curred more frequently than 5-endings.

3. Psychological taxing and pricing

In order to examine psychological taxing, consider a municipality’s tax setting

process. Assume that a single tax rate is set to cover a pre-determined level of expen-

ditures. The tax rate will correspond to the level of expenditures divided by the size

of the tax base. On an a priori basis, all tax rate endings are equally likely to occur.The rightmost digits in any municipality will be drawn from a random distribution.

As illustrated in the previous section, actual tax rate endings in Flemish munici-

palities are not distributed uniformly. There are two reasons that could explain this.

First, it should be remembered that all municipalities had a 0-ending tax rate until

1986. If, as has been suggested in the literature (Rose, 1985) changing the tax rate

is accompanied by high fixed (political) costs, it may be the case that municipalities

have not changed their tax rate since 1986. This would lead to an overrepresentation


of 0-ending taxes. Closer inspection, however, reveals that 80% of municipalities

have changed their tax rate at least once since 1986. Table 1 suggests that many

of those changes were to a 0-ending tax rate. Thus, inertia offers at best only a partial

explanation for the current distribution of tax rate endings.

A second reason why tax rate endings could be unevenly distributed is the pres-ence of psychological taxing. This occurs when political decision-makers exploit dis-

continuities in the demand curve around so-called tax points. This practice would be

the public sector analogue of psychological pricing in the private sector. The aim of

psychological pricing in the private sector is to increase sales. The underlying ratio-

nale is, then, that demand functions are not smooth curves, but that they display dis-

continuities – or more generally: that they become more elastic – around given price

points. Marginal price changes then lead to considerable changes in consumers’ will-

ingness to buy the good. By lowering a price just below a price point, sales can in-crease considerably.

Explaining unequal tax rate endings by psychological taxing implies following a

public choice approach to politics: the government exploiting tax points cannot be

considered to be a benevolent dictator. Rather, politicians – like voters – (also)

pursue their own objectives, irrespective of the electorate. The two current as-

sumptions in the public choice literature – vote-maximising and revenue-maximis-

ing behaviour on the part of politicians (Mueller, 1989) – are both compatible

with the notion of psychological taxing. Most generally, politicians can be seenas ‘‘selling’’ a policy. If tax points exist, taxing just below them increases citizens’

evaluations in a similar way as pricing below price points does in the market. This

evaluation can be expressed through the voting behaviour or (for non-residents)

through foot-voting. Around the discontinuities in the demand curve, politicians

can make their policy – and thus their jurisdiction – disproportionately more at-

tractive by lowering the tax rates just a little. The effect will be a relatively strong

increase in political support (Voice) or an in-migration of residents (‘‘negative’’

Exit).Two questions then arise, both with respect to the private and to the public sector:

(1) Do these discontinuities in demand curves actually exist? and (2) What explains

their existence? We consider both questions in turn. In the final subsection, we sum-

marise the main findings and discuss what psychological taxing is expected to look

like in the case of the Flemish local income tax rates.

3.1. Do discontinuities exist?

Answering this question boils down to showing that sales actually change dispro-

portionately around price or tax points. In spite of the attention that the marketing

literature has given to the explanation why price points exist, there is no real consen-

sus on whether the use of psychological pricing actually increases sales. A one page

communication in the American Economic Review over 50 years ago (Ginzberg,

1936) states that there was no unambiguous proof for an effect of ‘‘customary’’ (9-

ending) prices. Price-ending effects were reported to be item specific, though the au-

thor does not report very precise information on his results. Later, Dalrymple and


Haines (1970) and Georgoff (1972) found no significant effects of price endings on

sales. More recent analyses by Wisniewsky and Blattberg (see Nagle & Holden,

1995) and by Schindler and Kibarian (1996) do indicate substantial effects on sales

(notably of lowering prices to a 9-ending price). Some indirect evidence is given by

Blinder (1991), who finds that business executives do consider pricing points amongthe elements that actually affect price adjustments. Finally, Gendall, Holdershaw,

and Garland (1997) and Wedel and Leeflang (1998) show the presence of discontinu-

ities in demand in experimental settings.

As the notion of psychological taxing has – to our knowledge – not been part of

the research agenda in political economy before, it is self-evident that so far no ev-

idence exists on its influence on voting or migration decisions.

3.2. What could explain discontinuities?

Three explanations for discontinuities in demand functions have been suggested in

the literature: the underestimation effect, the perceived gain effect and the fact that

price endings may have symbolic meanings. The first two start from the empirical

observation that round numbers like 0 have a higher (psychological) accessibility

or availability (Tversky & Kahneman, 1973). The perceptual implication is that

numbers that come to mind more easily are used in thought more frequently (Schind-

ler & Kirby, 1997).� The underestimation effect arises because people favour round numbers in their

cognitive processing of price (Schindler & Kirby, 1997) – and therefore tax – infor-

mation. Confronted with multi-digit numbers, consumers or taxpayers can then fol-

low two strategies for encoding: rounding or truncation. The former implies that a

rounding rule is applied, for example ‘‘all digits lower than or equal to 5 are rounded

to 0; all digits higher than 5 are rounded to the next higher 0 ending’’. The latter sit-

uation clearly gives an overestimation effect. Truncation, on the other hand, means

that one only recognises the first digit(s) of a number and then uses the most acces-sible number (likely 0) to ‘‘fill the gap’’. A tax rate of 7.6% might thus be rounded to

8.0% or truncated to 7.0%. As truncation requires fewer digits to be processed and

no rounding rule to be applied, it requires less mental effort (Brenner & Brenner,

1982). It is therefore expected to be preferred under certain circumstances. For exam-

ple, in the public sector, it is well known that incentives to be well informed are often

extremely low. Rational ignorance can follow from the observation that the proba-

bility that one’s vote determines the political outcome is virtually zero (Downs,

1957). Under such circumstances, truncation may become the preferred strategy inencoding tax rates. For the Flemish tax rates, this would mean that voters disregard

the decimal digit. Still, the individual’s incentives to be well informed are likely to be

much larger when it comes to residence decisions. Thus, when considering Exit, an

individual may prefer a rounding strategy (or, of course, process the ‘‘complete’’

tax rate, including its precise ending).

Underestimation at given tax rates (prices) leads to more elastic – or rather dis-

continuous – demand around price points. In fact, the demand curve becomes a ‘‘ro-

tated step function’’, as in Fig. 2 where the tax points are indicated by the horizontal

price

Quantity

Fig. 2. Demand under truncation and rounding.


dotted lines. If all taxes are truncated, then the demand function will be perfectly

inelastic from a tax rate of 1.0 to one of 1.9; for tax rates between 2.0 and 2.9,

and so on. Governments, wanting to exploit these discontinuities will set 9-endingtax rates. If, on the other hand, taxes are rounded, then a similar type of demand

function will occur. In this case, the discontinuities will now occur at the points

towards which taxpayers round. For example, under the rounding rule mentioned

above, a tax rate of 7.5 will, just like a rate of 6.6 be perceived as a 7.0 tax rate. Thus,

demand will be perfectly inelastic for tax rates from 6.6 to 7.5. This means that

political opposition to a 7.5 or a 6.6 tax rate is equal while, of course, the former

tax rate allows provision of more public goods (and thus generates higher politi-

cal support). In such circumstances, we might, therefore, expect all tax rates toend in 5.

� The perceived gain effect refers explicitly to the notion of reference points as

understood in the literature on anomalies. Given their higher availability, round

numbers might serve as reference points (Schindler & Kirby, 1997). A 7, 8 or 9-end-

ing price or tax rate can then be seen as composed of two distinct parts: first, a

round number and, second, a small gain. A 7.7 tax, for example, would be per-

ceived as an 8.0 tax along with a 0.3 gain. Prospect theory and Thaler’s (1985)

transaction utility model, which builds on it, offer a theoretical rationalisation.The perceived gain effect corresponds to the hedonic framing and more precisely

to the silver lining effect in Thaler (1985, p. 202). In Thaler’s (1985) transaction util-

ity model, the total utility of a purchase depends not only on consumer surplus (or,

in the words of Thaler: on the acquisition utility), but also on the transaction utility.

The latter reflects the extent to which consumers consider the transaction to be a

good ‘‘deal’’. Transaction utility depends on how the actual price (here: tax rate)

compares to a reference price (here: reference tax rate). Assuming that acquisition

utility explains the position of the ‘‘basic’’ demand curve, it then follows that thiscurve becomes more elastic at places where transaction utility is positive as the

GAINSLOSSES

v(-8.0)+v(0.1)

v(-7.9)

V(-8.0)

+ 0.1%

- 8.0% -7.9%

v(0.1)

Fig. 3. Silver lining effect.


transaction utility generates a ‘‘surplus’’ making the good under consideration more

attractive.

The prospect theoretical basis for Thaler’s analysis is Kahneman and Tversky’s

(1979) value function. This value function is presented as an alternative for the con-

ventional utility function. The main premises are visualised in Fig. 3 where value vð�Þis a function of gains and losses relative from a reference point. The ‘‘initial’’ value

function – given by the plain line in Fig. 3 defines gains and losses relative from a

reference point. It can be seen that the value function is concave for gains and convex

for losses (v00ðxÞ < 0, x > 0; v00ðxÞ > 0, x < 0) and that it is steeper for losses than for

gains (vðxÞ < �vð�xÞ, x > 0). This reflects that people are loss averse and that they

consider a loss of a given amount in a more aversive way than a gain of the same

amount is attractive.

By being taxed, the taxpayer is confronted with a loss. For a tax which amounts to7.9%, the loss – pictured in Fig. 3 – equals vð�7:9%Þ. The perceived gain effect, then,

refers to the possibility that taxpayers ‘‘try to frame outcomes in whatever way

makes them happiest’’ (Thaler, 1985, p. 202). As such, the 7.9% loss might be mod-

erated if the taxpayer considers it as a tax of 8.0% (a larger loss – see Fig. 3) along

with a ‘‘discount’’ of 0.1% (a gain). The value associated with the tax, then, equals

vð�8:0%Þ þ vð0:1%Þ. This segregation (Thaler, 1985) of the 7.9% tax into two sepa-

rate components is preferred if vð0:1%Þ > vð�7:9%Þ � vð�8:0%Þ. This is clearly the

case in Fig. 3. Taxpayers are therefore expected to create themselves a silver liningeffect.


To illustrate the perceived gain effect, we can draw a ‘‘segregated value-function’’,

which is the dotted line in Fig. 3 starting at the value of the tax point 8.0%. It is clear

that segregation makes demand more responsive for taxes just below 8.0%. 2

� A final explanation for discontinuities in the demand function lies in symbolic

meanings that price (tax) endings may have. Such meanings of price endings may ap-ply to the price or to a non-price attribute of a product. Schindler (1991) gives no less

than 14 examples. Additionally, the symbolism might be a ‘‘pure’’ number effect. For

taxes, a symbolic meaning relating to the price-attribute could be that ‘‘unusual’’ tax

rate endings – say rightmost digits 3 or 4 – could be interpreted as ‘‘the result of a

more precise and careful pricing process’’ (Schindler, 1991, p. 795). Symbolic refer-

ences to non-price attributes are less relevant in the case of taxation, if only because

taxes – as opposed to charges – are by definition less identifiable as payments for

well-specified goods or services. This is especially the case when government relieson a multitude of tax instruments. Finally, symbolism might refer to a pure num-

ber-effect. An example of this, which is especially attractive given the occurrence

of many 8-endings in Flemish income tax rates is referred to by Kotler, Armstrong,

Saunders, and Wong (1999, p. 728) who write ‘‘Some psychologists argue that each

digit has symbolic and visual qualities that should be considered in pricing. Thus, 8s

are round and even and create a soothing effect, whereas 7s are angular and create a

jarring effect’’. The major weakness of the ‘‘symbolic’’ explanations is that they lack

the support of a firm (psychological) theory. As such they are open-ended in thesense that they might allow one to ‘‘explain’’ the occurrence of any tax rate ending.

3.3. What tax rate endings reveal psychological taxing?

The review of the literature makes clear that psychological taxing is not expected

to lead to a unique tax rate ending. Only under the assumption that taxpayers trun-

cate does the theory provide an unambiguous prediction: we expect all tax rates to

end in 9. If, however, taxpayers round according to the rounding rule mentioned,tax rates would end in 5. Of course, use of a different rounding rule may lead to a

different result. If, for example, only digits lower than 5 are rounded to 0, then we

expect tax rates to end in 4. As discussed, also the perceived gain effect predicts dif-

ferent possible tax rate endings. If 0 is the (only) reference point, then we expect tax

rate endings like 9, 8, 7, and so on. Strictly speaking it is not possible on theoretical

grounds to exclude with absolute certainty the occurrence of any other positive tax

rate ending under the perceived gain effect. Taxpayers could, for example, observe a

2 Of course, the dotted line takes precisely the same form as the value function does in the domain of the

gains. Also, additional segregated value functions (which are, really, parts of one and the same –

discontinuous – function) could be drawn, starting from all tax points. As such, it is obvious that – for

lower tax rates – the segregated value function will lie under the actual value function, indicating that

segregation will not be beneficial. For the same reason, ‘‘optimal segregation’’ may as well imply discounts

that are larger than 0.1%. It is a general rule, however, that the size of the ‘‘optimal discount’’ rises with the

level of the tax rate. Thus, from this perspective, 9-endings are expected to appear more frequently for

‘‘relatively low’’ tax rates.


tax of 7.3% as a tax of 8.0% with a gain of 0.7%. Excluding a 3-ending tax rate is

even less easy if taxpayers would use 5-endings as a reference point. Then the 7.3

tax would be seen as a 7.5 tax with a 0.2 gain.

All the above, however does not mean that the theories (leaving aside the sym-

bolic meaning explanations) are too open-ended and therefore useless for empiricalverification. The ‘‘rounding’’ version of the underestimation effect, as well as the per-

ceived gain effect, allow for testable assumptions (such as the positive relationship

between the tax rate ending and the tax level under the perceived gain effect).

In what follows, we concentrate on one unambiguous conclusion, which is com-

patible with both the underestimation and the perceived gain effects. Both predict

that psychological taxing will lower the probability that a tax rate ends in 0. For-

mally:

P ½RD ¼ 0jpsycho tax� < P ½RD ¼ 0�
and, for completeness,
P ½RD 6¼ 0� < P ½RD 6¼ 0jpsycho tax�

where P ½RD ¼ kjpsycho tax� gives the probability that psychological taxing under-

lies the actual tax choice process resulting in a given rightmost digit (k) and

P ½RD ¼ k� is without such psychological taxing. As such, our empirical approach

resembles that of Dalrymple and Haines (1970) who investigated the effect on sales

from using non-00 ending prices.

4. Hypotheses with respect to positive rightmost digits – RD>0

Of course, we cannot directly observe the psychological motivations of govern-

ment officials deciding on the tax rate. Thus, it is impossible to find direct evidence

that specific tax rates are chosen because of the presumed existence of tax points.

What we can do, however, is identify presumed determinants of psychological taxa-

tion and test whether these explain the occurrence of positive rightmost digits. Theanalogue with private sector pricing is, again, our starting point.

The previous paragraphs showed how ‘‘psychological’’ tax rate endings could af-

fect public sector demand. This demand corresponds with the incumbent’s popular-

ity (demand for his policy) or with the demand for residence in the jurisdiction. We

assume that the use of psychological taxing depends on the balancing of marginal

costs and benefits from doing so. The marginal cost of using a psychological tax is

assumed identical for all municipalities. These costs may reflect administrative costs

resulting from handling more complex tax rates and the utility losses associated withthe fact that a lower tax price may not allow to cover the expenditures necessary to

pursue a given (ideological) policy. The marginal benefit from using a psychological

tax rate reflects the increased popularity (‘‘Voice’’) or attractiveness (‘‘negative

Exit’’) of the municipality.

The general idea behind the empirical analysis is that marginal benefits of psycho-

logical taxing are positively related to the elasticity of demand for the incumbent’s


policy (Huston & Kamdar, 1996, give a formal presentation in the case of consumer

price points). So, the presence of psychological taxing should be more prevalent in

municipalities where demand is, ceteris paribus, more elastic. Any determinant influ-

encing the (tax) price elasticity of demand is expected to potentially influence the use

of psychological taxing. In what follows, we proceed by identifying these factors forboth the Voice and Exit dimensions of demand.

First, we consider the elasticity of the incumbent’s popularity (‘‘Voice-demand’’).

As for any product, price elasticity depends positively on the number of substitutes.

Assuming that each political party proposes a given – possibly ideologically in-

spired – policy, the elasticity of demand for this policy will be positively related to

the number of substitutes. In local authorities, competing political parties offer these.

This leads to a first hypothesis:

H1: The use of positive rightmost digits is positively related to the number of polit-

ical parties.

Income disparities within a municipality are a second determinant of the elasticity

of demand. Large disparities are expected to make the population more sensitive to

the level of a tax which, like the local income tax, is highly redistributive in nature.

This is the case because the actual redistribution generated by any income tax de-

pends on the rate structure as well as on the pre-tax income distribution. If all tax-payers have identical incomes, then the tax will generate no redistribution at all, no

matter how ‘‘progressive’’ its rate structure. In such a situation, the tax is just an in-

strument of allocation. The demand function then reflects the (tax) price elasticity of

‘‘allocative expenditures’’. To the extent that pre-tax incomes differ, the tax also be-

comes an instrument of redistribution. So, in addition, demand also reflects the tax

price elasticity of redistributive ‘‘expenditures’’. In general, we expect that:

H2: The use of positive rightmost digits is positively related to the income dispersionwithin the municipality.

The composition of the electorate along other dimensions (than income) may also

be relevant. For example, the ideological composition may affect the elasticity of de-

mand. This idea corresponds with the notion that – in a private market – consumers

can be divided into groups according to the price elasticity of their demand. Hansen

(1983) argues that taxation is a more salient issue for right-wing parties. Assuming,

this salience carries over to right-wing voters, we expect that such voters are moresensitive to differences in tax rates. Demand elasticity will thus depend on the share

of right-wing voters in the electorate. More precisely, we expect:

H3: The use of positive rightmost digits is positively related to the ideological posi-

tion of the electorate along a left–right axis.

To the extent that the marginal political costs of taxation increase in the level of

taxation (as assumed in Hettich & Winer, 1984, 1999), we expect psychological


taxing to become more prevalent when taxes are high. The perceived-gain effect

makes a similar prediction. Indeed, as can be seen from Fig. 3, the value of a given

gain – vðxÞ, with x > 0 – is more likely to outweigh the marginal loss at vð�yÞ for

y > 0 to the extent that y is larger – a straightforward consequence of the convexity

of the value function in the domain of losses. Thus:

H4: The use of positive rightmost digits is positively related to the level of the tax

rate.

The previous four hypotheses refer to ‘‘Voice-demand’’. Taking now also into ac-

count the possible mobility of taxpayers, the tax rate elasticity of the demand for res-

idence has to be considered. As tax rates and other characteristics of public policy

are likely to have only marginal effects on choice of residence, we expect the roleof taxation to be more important in municipalities which, ceteris paribus, have a high

gross migration (‘‘population turnover’’):

H5: The use of positive rightmost digits is positively related to the municipality’s

‘‘population turnover’’.

Allied to this, the tax rate in neighbouring municipalities may be of relevance. In-

deed, the elasticity of the migration function with respect to taxes can be expected toincrease in the intermunicipal tax differences (for example, because of fixed migration

costs which ‘‘prevent’’ citizens to react to small tax differences). Low tax as well as

high tax neighbours can lead to strong migration effects (out-migration and in-

migration, respectively). Therefore, the relevant determinant of the elasticity of de-

mand is the absolute value of the tax differential:

H6: The use of positive rightmost digits is positively related to the absolute differ-

ence between the own tax rate and the tax rate in neighbouring municipali-ties.

Following prospect theory, loss aversion implies that the difference with low tax

neighbours is more relevant. Therefore, we have:

H7: The effect in H6 is stronger in municipalities with tax rates above those in neigh-

bouring municipalities.

It should be noted that the distinction that we make between Voice- and Exit-

determinants of psychological taxing is not unambiguous. For example, tax rates

in neighbouring municipalities may not only affect Exit. They may also affect Voice.

This is actually the central argument in the mimic (or political yardstick competition)

literature mentioned earlier.

These hypotheses give an indication of how the empirical estimation should

be formulated and the anticipations, which are explored empirically in the next sec-

tion.


5. Empirical analysis

5.1. Empirical specification

In order to examine the hypotheses above, the following specification is initiallyexamined:

RD ¼ a0 þ b0NUMPARi þ b1INEQi þ b2ELECi þ b3TAX98i

þ b4POPTURi þ b5NEIGHi þ b6D1i þ b7D1i�NEIGHi þ ei: ð1Þ

As the matter under investigation is to examine the circumstances under which

Flemish municipalities use a positive number as a rightmost digits (RD) as opposed

to a tax rate ending in 0, the empirical model thus has a dichotomous dependentvariable. This variable takes a value ‘‘1’’ if the 1998 local income tax rate in munic-

ipality i ends in a positive number; it equals zero when the tax rate ends in zero. Thus

estimation will use the standard probit analysis (see Greene, 1999) to estimate the

effects.

The independent variables are the determinants of tax price elasticity of demand

(and therefore determinants of the use of psychological taxing). They are introduced

in the order imposed by the discussion in Section 4 (with descriptive statistics in Ap-

pendix A).The first four independent variables relate to the elasticity of Voice-demand, i.e.

they are determinants of the sensitivity of the incumbent’s popularity to changes

in tax rates. As a proxy for the number of substitutes which voters face when express-

ing their preference in the ballot box, we use NUMPARi. This is the number of

political parties that gathered at least 2% of the votes at the most recent – 1994 –

election (considering only parties with more that 5–10% – of the votes did not affect

our results in any significant way). Of course, the incumbent may be – and in Flan-

ders often is – a coalition of parties. Theoretically, for each party X the relevant‘‘number of substitutes’’ corresponds with the number of possible coalitions that

can be formed excluding X . We use the number of political parties as a proxy for

this. As hypothesis 1 suggests a positive effect on the use of positive rightmost digits,

b0 should be positive.

Hypothesis 2 relates the use of positive tax endings to the shape of the income dis-

tribution. The income dispersion in municipality i is measured by INEQi which is the

ratio of the interquartile range (third minus first quartile) for the income variable to

its median value. This indicator is the only income inequality measure that is avail-able at the municipal level. High values reflect stronger income inequality so we ex-

pect b1 > 0. ELECi is a proxy for the ideology of the electorate (hypothesis 3). It is

calculated as the weighted average of the votes at the 1994 elections. Weights corre-

spond with the ideological position of the respective political parties on a left–right

axis (Ashworth & Heyndels, 1997). Finally, as a last ‘‘Voice’’ determinant, TAX98igives the municipality’s own income tax rate. Hypotheses 3 and 4 predict positive

values for b2 and b3, respectively.


Considering also the demand for residence (Exit), POPTURi is a proxy for the

average population turnover or gross migration movement. It corresponds with

the average value over the period 1985–1996 of in- and out-migration divided by

the municipality’s total population. We expect b4 > 0.

Finally, again, associated the model is augmented with the absolute difference be-tween a municipality’s tax rate and the average tax rate in the neighbouring munic-

ipalities (NEIGHi). This absolute difference is an indicator for the potential fiscal

migration in or out of municipality i. Therefore, we expect b5 to be positive.

Prospect theory predicts that the responsiveness to positive tax differences will be

larger (as these relate to losses for the taxpayer). To capture this effect, we introduce

an interaction term D1i�NEIGHi, where D1i equals 1 if the difference between mu-

nicipality i’s tax rate and the average among its neighbours is positive. Such a pos-

itive difference indicates that municipality i is ‘‘more expensive’’ than its averageneighbour which, according to hypothesis 7, will increase the likelihood of psycho-

logical taxing. In addition, the dummy, D1i, is also added to the equation to reflect

that there may be some fixed effect of being above neighbours as well as the variable

effect relating to the size of the tax which will be picked up above. Thus, b6 and b7 arealso expected to be positive.

In this approach, all neighbouring municipalities are treated alike. It might be ar-

gued that this does not capture the fiscal reality at the local level. A given average tax

rate among neighbouring municipalities might coincide with more or less variationwith, possibly, extremely high and/or low tax rates in single neighbours. As an alter-

native specification, we replace NEIGHi by NEMINi and NEMAXi. The former

(latter) gives the absolute difference between municipality i’s income tax rate and

the lowest (highest) tax rate among neighbouring municipalities. To test for the effect

of loss aversion (H7), we add interaction terms D2i�NEMINi and D3i�NEMAXi to-

gether with the fixed effects D2i and D3i. The latter dummy takes a value of 1 when a

municipality’s tax rate is higher than the highest tax rate among its neighbours, i.e.

D3¼ 1 indicates that a municipality very ‘‘expensive’’. Thus,

RD ¼ a0 þ b0NUMPARi þ b1INEQi þ b2ELECi þ b3TAX98i

þ b4POPTURi þ b52NEMINi þ b62D2i þ b72D2i�NEMINi

þ b53NEMAXi þ b63D3i þ b73D3i�NEMAXi þ ei ð2Þ

For ease of estimation and to reflect the minority of cases, D2i is defined as being

below the neighbours’ minimum tax (thus D2i ¼ 1 indicates that a municipality’s taxcan be considered a tax haven). Overall, the anticipation is that all signs will be

positive except for those that involve D2i, which will be negative.

5.2. Empirical results

Table 2 summarises the results of the probit analysis undertaken. The third col-

umn gives coefficients and corresponding standard errors for the basic estimation

equation (1) whilst the fourth column gives the estimation using the definitions with


the maximum and minimum neighbourhood taxes, Eq. (2). Columns 5, 6 and 7 give

various restricted versions of column 4.

It can be seen that in terms of fit by whatever measure, the specification of the

model incorporating maximum and minimum measures dominates the specification

using average neighbourhood measures. Further, applying the non-nested J -tests,adapted for probit models (Davidson & MacKinnon, 1993), indicated that there is

no information in the column 3 (average) model, which would improve the maxi-

mum/minimum specification (columns 4, 5 and 6). However, the reverse test is such

that if there is significant information hence the latter model dominates. A consider-

ation of the diagnostic tests also indicates that the ‘‘average’’-model is mis-specified

but the models of columns 4, 5 and 6 pass all diagnostic tests for normality and het-

eroscedasticity. The latter test being both for included variables and excluded vari-

ables. 3 In the case of column 7, it can be seen that the omission of D2i leads toheteroscedasticity from this source and so the preferred models are those including

D2i.

Examining column 3 shows that all coefficients apart from those relating to the

neighbouring tax rates have the expected sign. The coefficients of NUMPARi,

INEQi, ELECi, TAX98i and POPTURi all seem to enhance the probability that

the last digit of the tax rate is different from zero. Similar results are found in column

4. However, it is clear that a number of these variables are individually insignificant

and when tested are also jointly insignificant. Leaving out the most insignificant vari-ables, which is an appropriate restriction, leads to the results in column 5. Significant

effects are found for INEQi and TAX98i of the voice variables and an effect for both

the maximum and minimum of the neighbours’ taxes. 4

Income inequality clearly affects the use of psychological taxing. In municipalities

where large income disparities are observed, the probability that a tax rate has a pos-

itive ending is larger. This indicates that voter’s sensitivity to changes in taxes is lar-

ger to the extent that such a change not only corresponds with changes in the level of

public expenditures but also to changes in the level of income redistribution. Ceterisparibus, low-income voters will have more interest in an increase in taxation,

whereas high-income voters are expected to oppose such an increase. We also find

a significant and positive effect from the actual level of the tax rate, giving support

3 The restricted version of column 3 contains only the intercept, TAX and INEQ and so is clearly

dominated by the preferred model. Space precludes presenting all tests of heteroscedasticity of variables.

Any omissions are available on request from the authors. From the table, it should be noted that whilst

model [1] in column 3 passes the White test for heteroscedasticity using the variables in the model, it fails a

test for heteroscedasticity using the significant variables from the other model [2] reinforcing the J -testresult.

4 Of the omitted variables, the only variable that might be included is NUMPAR, which has a t-statisticabove unity. Its inclusion improves the number of correct predictions by 4. If included, this suggests that

incumbent politicians more easily use psychological taxing in contexts where voters have more political

substitutes to turn to. This is in line with the idea that demand for any given politician’s policy is more

elastic to the extent that more substitute policies (platforms) are available to the voter.

Table 2

Probit estimation of the decision to set a psychological tax rate

Independent

variable

Variable

name

Version 1 Version 2 Version 2

(restricted)

Version 2

(restricted)

Version 2

(restricted)

Intercept )6.852 (2.197) )7.371 (2.133) )5.490 (1.363) )5.668 (1.319) )5.008 (1.220)

Number of parties NUMPAR 0.064 (0.052) 0.066 (0.053)

Electorate ELEC 0.108 (0.252) 0.110 (0.264)

Inequality INEQ 0.027 (0.010) 0.027 (0.010) 0.029 (0.009) 0.027 (0.008) 0.027 (0.008)

Tax rate TAX98 0.424 (0.201) 0.455 (0.192) 0.305 (0.126) 0.350 (0.118) 0.269 (0.102)

Population turnover POPTUR 0.782 (9.051) 1.160 (9.108)

Neighbour effects NEIGH )0.083 (0.306)

D1 0.019 (0.249)

D1�NEIGH )0.221 (0.463)

NEMAX 0.163 (0.187)

D3 2.248 (0.932) 1.156 (0.375) 1.122 (0.373) 1.134 (0.373)

D3�NEMAX )2.118 (1.603)

NEMIN )0.024 (0.074)

D2 1.100 (0.487) 1.108 (0.476) 0.420 (0.279)

D2�NEMIN )1.018 (0.615) )1.062 (0.590)

LL )166.933 )158.609 )160.739 )162.425 )163.545LRI )178.169 )178.169 )178.169 )178.169 )178.169v2 22.472 (8) 39.119 (11) 34.860 (5) 31.486 (4) 29.238 (3)

v2ðRÞ 4.259 (6) 7.633 (7) 9.881 (8)

R2 0.127 0.210 0.190 0.173 0.162

j 0.046 0.190 0.175 0.173 0.151

q2 0.739 0.759 0.759 0.759 0.752

Diagnostic Tests

J Test Col 3 (Col 6) ()3.049) )0.003 )0.002 )1.075 0.919

RESET2 0.210 )1.248 0.299 0.108 0.617

RESET3 )0.162 )1.481 0.454 0.443 0.127

Normality 1.314 (2) 0.767 (2) 0.746 (2) 2.061 (2) 2.934 (2)

Heteroscedasticty

INEQ 0.341 )1.184 )0.771 0.716 0.460

TAX 0.440 1.144 0.599 )0.942 )0.603

756

J.Ashworth

etal./JournalofEconomic

Psychology24(2003)741–762

D3 )3.800 )1.456 1.009 0.397 0.486

D2 )3.056 0.818 0.392 )0.797 )2.240D2�NEMIN 1.814 )1.040 )1.111 )0.599 )0.673NEIGH 0.395 1.328 1.426 1.578 1.277

NEMIN )1.706 )0.738 0.444 0.346 0.562

White 25.550 (28) 38.120 (32) 14.73 (9) 13.26 (7) 5.517 (5)

Notes: Estimated standard errors are in parentheses; LL is the maximised value of the log-likelihood function; LL0 is the log-likelihood computed with only

the constant term; LRI is the likelihood ratio index; v2 is the test of overall significance of the equation; v2ðRÞ is the test of the omission of variables from the

general model with R the number of omitted variables; Pseudo-R2 is a measure as suggested by Veall and Zimmermann (1996), following Aldrich and Nelson

(1984) and Veall and Zimmermann (1992); q2 is the proportion of predictions that is correct; and j is the Veall and Zimmermann (1996) measure of

proportional reduction in error from Bishop, Fienberg, and Holland (1975). Diagnostic tests are computed following Pagan and Vella (1989) and follow a t-distribution. The only exceptions are those for White unknown form heteroscedasticity test and normality which are computed following Chesher and Irish

(1987) and follow a v2-distribution with degrees of freedom as indicated.

J.Ashworth

etal./JournalofEconomic

Psychology24(2003)741–762

757


for hypothesis 4. Higher levels of taxation induce a higher frequency of positive tax

rate endings, due to the increasing marginal political costs of taxation.

As mentioned, the tax setting process is not affected by the average tax rate in

neighbouring municipalities. This result might not come as a complete surprise in

the present setting. Previous work on tax mimicking (Heyndels & Vuchelen, 1998)and on opinions on the level of tax rates (Ashworth & Heyndels, 1997) in the context

of Flemish municipalities have found that neighbourhood effects for local income

taxes, if present, were much more modest than for local property taxes. Still, the re-

sults in the preferred equation (in column 5) in Table 2 give a different picture.

Examining column 4 initially, the signs of NEMINi, D2i�NEMINi, D3i�NE-

MAXi are negative, while those for D3i, NEMAXi and D2i are positive. The impli-

cations of this are somewhat complex, as there are indications of support for the

hypotheses of the previous section but also some contradictions. In the restricted ver-sion of the model (column 5) we omit the insignificant variables leaving only D2i and

D3i, together with D2i�NEMINi, which is significant at the 10% level of signifi-

cance. 5 There is clear evidence to indicate that psychological taxing depends heavily

on the highest tax rates in neighbouring municipalities. Being above the highest (i.e.

when D3¼ 1) automatically increases the likelihood of psychological taxing. This in-

dicates that politicians turn to psychological taxing significantly more in situations

where their tax rate is out of line with the tax rates in neighbouring municipalities,

in particular in those municipalities where the tax rate is higher than the highest taxrate among its neighbours. A ‘‘negative tax haven effect’’ might imply that in such

municipalities taxation becomes a more salient political issue. While the mere fact

of having a tax rate that is higher than the maximum tax rate among neighbours

stimulates psychological taxing, the actual size of NEMAXi does not seem to have

any significant effect.

However, it appears that that there is a different operation at the lower end. Here,

contrary to expectations, there is a greater likelihood of psychological taxing if the

authority is below the neighbours’ minimum taxation. We find that D2i is signifi-cantly positive instead of negative (note, however, that this effect is such that it is off-

set once the tax is more than one percentage point below that of the minimum

neighbour as can be seen from the coefficient on D2i�NEMINi). A possible (ex post)

explanation for the positive effect of D2i is that a municipality with very low taxes

(relative to any of its neighbours) tries to draw attention to this fact. As discussed

in Section 3, it may do so by using the symbolic meaning of the ‘‘unusual’’ tax rate

to stress a ‘‘price-attribute’’ (in the context here: the fact that the tax is low).

In summary, we find general support for the hypotheses outlined in the previoussection. In particular, there are significant effects towards the setting of a psycholog-

ical tax from the size of the tax rate and increased inequality in the municipality.

5 Given the 10% significance of D2�NEMIN, the last two columns are also presented. It can be seen

that removing this variable affects the significance of D2 taking it to the margin of significance. Thus, some

caution should be exercised in the interpretation relative to the neighbours’ lowest tax.


These tendencies are supplemented when extreme taxes are set relative to the neigh-

bouring municipalities.

6. Conclusion

Through psychological pricing, price-setters in the private sector try and exploit

discontinuities in the demand function around price points. As a general rule, this pol-

icy is more successful – sales increase more for given price changes – to the extent that

demand is more elastic. The same people that have a demand for apples, for television

sets or for any other good in the private market have a demand for public policies. In

a context of local governments, this demand is expressed through voting behaviour or

through choice of residence. Therefore, politicians may use psychological taxing toexploit discontinuities in this public demand. Lowering tax rates below so-called

tax points may increase citizen-voters’ demand for public policy considerably.

Analysing the main theoretical arguments for the existence of price points, and

applying them to the public sector, suggests that psychological taxing reveals itself

by the use of non-0 ending tax rates. The tax rate endings of the local income taxes,

which are set by 308 Flemish municipalities in the fiscal year 1998, suggests the pres-

ence of psychological taxing. Non-0 endings occur more frequently in municipalities

where demand for public policy is more elastic (and where, therefore, the benefits tothe politicians from setting a tax just below a tax point is higher). Positive effects

arise from the pre-tax income inequality and from the level of the tax rate. The latter

effect is reinforced in those municipalities where the existing tax rate is above the av-

erage tax rate in neighbouring municipalities and below their neighbours’ minimum,

although this effect has a limited effect and is offset the further below the minimum

the tax is set.

These results are supportive of the view that decision-making in the private and in

the public sector show clear resemblance. Obvious implications are that concepts andempirical results from consumer research have immediate relevance for the analysis

of public sector decision-making. More generally, our results illustrate the presence

of an, as yet, unstudied anomaly in taxation. As such, they may be an incentive for

public sector economists to critically examine the rational choice paradigm and, for

positive purposes, to search for a more accurate predictive model (see also Frey &

Eichenberger, 1989, 1991). From our examination of the literature on psychological

pricing, prospect theory is a prominent candidate. Quattrone and Tversky (1988) al-

ready illustrated how prospect theory helps explaining some well-known anomaliesin political science. The literature on psychological taxing can help to augment the

existing tax choice literature (Hettich & Winer, 1999) by introducing a more accurate

model of the voter.

The very existence of psychological taxing raises the question why the exploitation

of discontinuities around tax points occurs. In the private sector exploitation of

discontinuities around price points is assumed to occur by sellers who have clearly

distinct interests from the buyers. In the public sector such antagonism is not self-

evident. In a model of benevolent government (underlying much of the �public


finance’ approach to government) the government or tax setter is solely representing

the electorate: government has no �will of its own’, it is an instrument that voters use

to translate their preferences into policies. From such a perspective, the occurrence

of psychological taxing means that voters want it to occur. This could suggest that

voters try to ‘‘(. . .) frame outcomes in whatever way that makes them happiest’’(Thaler, 1985, p. 202). Still, the model of psychological taxing is more in line with

the descriptively more powerful politico-economic approach to government where

the interests of politicians and voters do not necessarily coincide. Then, taxes are

set such that political support and/or demand for residence are maximised. The lit-

erature on private sector pricing may suggest a series of strategic considerations for

politicians, especially with respect to the formation of reference points by the elector-

ate (see Puto, 1987, for an illustration with respect to buying decisions). This aspect

is likely of high political relevance as it can give clues to parties and politicians onhow to �optimally’ communicate with the electorate.

Finally, and given that our empirical analysis is the first of its kind, the external

validity of the analysis should be considered. Of course, only additional empirical

work can unambiguously demonstrate whether or not psychological taxing is a gen-

eral phenomenon of tax policy. Still, it can be expected that a number of institutional

characteristics will be of immediate relevance. For example, we analyse policy-mak-

ing in democratic contexts. In a non-democratic setting, (elasticity of) �Voice-demand’ is an empty concept. Further, we analysed policy-making in a context ofrepresentative government. The external validity of our results in a context of direct

democracy is not self-evident. Indeed, in such a setting the antagonism between vot-

ers and tax setting politicians may be absent (or less prominent). It may be argued

that testing for psychological taxing in a context of direct democracy could be seen

as a test of Thaler’s �self-framing’ discussed in the previous paragraph. It is clear,

however, that direct democratic decision-making on taxation is the exception rather

than the rule. Typically politicians and voters can realistically be distinguished as

separate bodies with possibly conflicting interests. Democracy makes �Voice-demand’ a relevant concept. It does not, however, make �Exit-demand’ relevant

by definition. The �Exit’ aspect of demand implies that the tax base is mobile across

jurisdictions. For this reason, psychological taxing is more likely in a context of

small-scale jurisdictions like in the federal structure in our own analysis, at least

for residence based taxes like (local) income taxes. Finally, as increasing mobility

of tax bases is an important characteristic of today’s world in general, this can be

expected to increase the use of psychological taxing. For example, the increasing mo-

bility of citizens and particularly corporations as a consequence of (European) uni-fication may be a source for psychological taxing both in personal and corporate

income taxation.

Acknowledgements

An earlier version of this article was presented at a seminar at the Institute for

Empirical Research, University of Zurich. We thank Matthias Benz, Bruno Frey,


Reto Jegen, Marcel Kucher and Alo€ııs Stutzer for valuable and highly stimulating

comments.

Appendix A. Descriptive statistics

Minimum Maximum Mean Std. dev.

NUMPAR 2.00 11.00 4.92 1.61

INEQ 68.70 134.80 92.25 10.34

ELEC 3.81 5.70 5.00 0.32TAX98 0 9.00 6.67 1.11

NEIGH 0 8.50 0.66 0.89

NEIGH�D1 0 8.50 0.38 0.90

NEMIN 0 8.50 1.17 1.35

NEMIN�D2 0 8.50 0.16 0.75

NEMAX 0 8.50 0.91 1.07

NEMAX�D3 0 1.00 0.03 0.13

POPTUR 0.02 0.09 0.04 0.01

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