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The Importance of Habit Formation for Environmental Taxation

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Author Info

  • Löfgren, Åsa

    ()
    (Department of Economics, School of Business, Economics and Law, Göteborg University)

  • Nordblom, Katarina

    ()
    (Department of Economics, School of Business, Economics and Law, Göteborg University)

Abstract

We analyze how habit formation affects optimal environmental taxation, when consumption of a habitual good causes a negative external effect on the environment. In a simple two-period model, we show that optimal taxation is still Pigouvian, where tax rates equal marginal damage in each period. However, the magnitudes of the tax rates are affected by habit formation. Using simulations we show that since consumption of the habitual good increases over time, so does the optimal tax rate, implying a higher tax rate in period two than in period one. The discrepancy increases in habitual strength. Given the development of the tax rates over time we discuss the welfare loss from imposing a secondbest environmental tax and its relation to habitual strength. Further, we analyze how optimal taxation changes if we relax the assumption of time-consistency.

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File URL: http://hdl.handle.net/2077/2710
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Bibliographic Info

Paper provided by University of Gothenburg, Department of Economics in its series Working Papers in Economics with number 204.

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Length: 18 pages
Date of creation: 27 Apr 2006
Date of revision:
Handle: RePEc:hhs:gunwpe:0204

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Postal: Department of Economics, School of Business, Economics and Law, University of Gothenburg, Box 640, SE 405 30 GÖTEBORG, Sweden
Phone: 031-773 10 00
Web page: http://www.handels.gu.se/econ/
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Keywords: Optimal taxation; environment; habit formation; secondbest; myopia;

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References

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  1. David Bowman & Deborah Minehart & Matthew Rabin, 1994. "Loss aversion in a consumption/savings model," International Finance Discussion Papers 492, Board of Governors of the Federal Reserve System (U.S.).
  2. Shane Frederick & George Loewenstein & Ted O'Donoghue, 2002. "Time Discounting and Time Preference: A Critical Review," Journal of Economic Literature, American Economic Association, vol. 40(2), pages 351-401, June.
  3. Raquel Carrasco & José M. Labeaga & J. David López-Salido, 2005. "Consumption and Habits: Evidence from Panel Data," Economic Journal, Royal Economic Society, vol. 115(500), pages 144-165, 01.
  4. Jonathan Gruber & Botond Köszegi, 2001. "Is Addiction "Rational"? Theory And Evidence," The Quarterly Journal of Economics, MIT Press, vol. 116(4), pages 1261-1303, November.
  5. Charles Ballard & John Goddeeris & Sang-Kyum Kim, 2005. "Non-Homothetic Preferences and the Non-Environmental Effects of Environmental Taxes," International Tax and Public Finance, Springer, vol. 12(2), pages 115-130, March.
  6. Pollak, Robert A, 1970. "Habit Formation and Dynamic Demand Functions," Journal of Political Economy, University of Chicago Press, vol. 78(4), pages 745-63, Part I Ju.
  7. Ronald Wendner, 2004. "Frames of reference, the environment, and efficient taxation," Economics of Governance, Springer, vol. 6(1), pages 13-31, January.
  8. Becker, Gary S & Murphy, Kevin M, 1988. "A Theory of Rational Addiction," Journal of Political Economy, University of Chicago Press, vol. 96(4), pages 675-700, August.
  9. O'Donoghue, Ted & Rabin, Matthew, 1997. "Doing It Now or Later," Department of Economics, Working Paper Series qt7t44m5b0, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  10. Jonathan Gruber & Botond Koszegi, 2000. "Is Addiction "Rational"? Theory and Evidence," NBER Working Papers 7507, National Bureau of Economic Research, Inc.
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Cited by:
  1. Elisabeth Gsottbauer & Jeroen Bergh, 2011. "Environmental Policy Theory Given Bounded Rationality and Other-regarding Preferences," Environmental & Resource Economics, European Association of Environmental and Resource Economists, vol. 49(2), pages 263-304, June.

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