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Adaptation, Anticipation-Bias and Optimal Income Taxation

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  • Thomas Aronsson
  • Ronnie Schöb

Abstract

Adaptation is omnipresent but people systematically fail to correctly anticipate the degree to which they adapt. This leads individuals to make inefficient intertemporal decisions. This paper concerns optimal income taxation to correct for such anticipation-biases in a framework where consumers adapt to earlier consumption levels through a habit-formation process. The analysis is based on a general equilibrium OLG model with endogenous labor supply and savings where each consumer lives for three periods. Our results show how a paternalistic government may correct for the effects of anticipation-bias through a combination of time-variant marginal labor income taxes and savings subsidies. Furthermore, the optimal policy mix remains the same, irrespective of whether consumers commit to their original life-time plan for work hours and savings decided upon in the first period of life or re-optimize later on when realizing the failure to adapt.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 3840.

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Date of creation: 2012
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Handle: RePEc:ces:ceswps:_3840

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Keywords: optimal taxation; adaptation; habit-formation; anticipation-bias; paternalism;

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  1. Clark, Andrew E. & Frijters, Paul & Shields, Michael A., 2007. "Relative Income, Happiness and Utility: An Explanation for the Easterlin Paradox and Other Puzzles," IZA Discussion Papers 2840, Institute for the Study of Labor (IZA).
  2. Oswald, Andrew J. & Powdthavee, Nattavudh, 2006. "Does Happiness Adapt? A Longitudinal Study of Disability with Implications for Economists and Judges," IZA Discussion Papers 2208, Institute for the Study of Labor (IZA).
  3. Jody Overland & Christopher D. Carroll & David N. Weil, 2000. "Saving and Growth with Habit Formation," American Economic Review, American Economic Association, American Economic Association, vol. 90(3), pages 341-355, June.
  4. Tuomala, Matti, 1990. "Optimal Income Tax and Redistribution," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780198286059, October.
  5. Wendner, Ronald & Goulder, Lawrence H., 2008. "Status Effects, Public Goods Provision, and the Excess Burden," MPRA Paper 8260, University Library of Munich, Germany.
  6. Edgeworth, Francis Ysidro, 1881. "Mathematical Psychics," History of Economic Thought Books, McMaster University Archive for the History of Economic Thought, McMaster University Archive for the History of Economic Thought, number edgeworth1881.
  7. Oswald, Andrew J., 1983. "Altruism, jealousy and the theory of optimal non-linear taxation," Journal of Public Economics, Elsevier, Elsevier, vol. 20(1), pages 77-87, February.
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