Optimal Taxation in Lifecycle Economies in the Presence of Commitment and Temptation Problems

Source abstract

Self-control problems affect consumption, saving, and labor supply, with implications for tax policy. We study optimal taxation with the self-control preferences of Gul and Pesendorfer. Krusell et al. showed that with these preferences, savings should be subsidized; under logarithmic utility, they showed that the subsidy should rise with age. We extend their analysis by adding a labor–leisure choice and comparing investment, capital income, consumption, and labor income taxes. When temptation applies to the consumption–leisure bundle, a single investment or capital income subsidy corrects both the consumption and the leisure margins in partial equilibrium, whereas consumption taxes require a matching labor tax adjustment. Non-separability between consumption and leisure does not change this requirement. With inelastic labor, the same subsidy rates implement the commitment allocation in a two-period general equilibrium model. In a logarithmic T-period partial equilibrium model with elastic labor, the same subsidy formulas and age profile hold under an interior menu condition. In a calibrated example with annual periods, implementing the commitment allocation raises welfare by about 7 percent of consumption in the baseline. The gain varies widely across empirically plausible degrees of present bias.