Optimal Taxation of Internalities: The Role of Market Incentives

Abstract

This paper analyzes the optimal taxation of goods when consumers fail to maximize their own utility, imposing internalities on themselves. This can happen due to imperfect information, cognitive bias, or lack of willpower, among other causes. I relax two ubiquitous assumptions found in other work on this topic by studying imperfect competition and the incentive firms have to de-bias consumers. Contrary to standard results, I find that (i) internality correction, even if costless, is not always desirable; (ii) optimal tax rates are generally not equal to marginal internalities; and (iii) firm de-biasing incentives attenuate the optimal internality tax or subsidy.

Keywords: Cognitive bias, imperfect competition, internality, internality tax, market failure, optimal taxation

JEL Classification: D03, D43, D61, H21, H23, H32