Car notches: Strategic automaker responses to fuel economy policy

Notches – where marginal changes in behavior lead to discrete changes in a tax or subsidy – figure prominently in many policies. In this paper, we analyze notches in fuel economy policies, which aim to reduce negative externalities associated with fuel consumption. We provide evidence that automakers respond to notches in the Gas Guzzler Tax and mandatory fuel economy labels by precisely manipulating fuel economy ratings so as to just qualify for more favorable treatment. We then describe the welfare consequences of this behavior and derive a welfare summary statistic applicable to many contexts. In brief, notches are an inefficient substitute for smooth policies because they create marginal incentives that vary among decision makers and induce some individual actions that have negative net social benefits.

► A tax has notches if marginal changes in attributes can lead to discrete tax changes. ► Fuel economy taxes, which aim to reduce fuel-related externalities, have notches. ► Automakers strategically respond to these notches by modifying certain vehicles. ► This response improves fuel economy, but it is inefficient and may lower welfare. ► A similar inefficient response is induced by rounding rules for fuel economy labels.