Too Slow a Change? Deep Habits, Consumption Shifts and Transitory Tax Policy
University of Gothenburg, School of Business, Economics, and Law, Working Paper in Economics No. 701
52 Pages Posted: 7 Sep 2017
Date Written: June 15, 2017
This paper studies shifts in the consumption bundle when consumption is subject to habit formation, and consumers do not internalize this habit formation process. Habits are good-specific, or ’deep’, and cause persistence in good-specific consumption. In addition, at the aggregate level, habits act as benchmark against which consumption is evaluated. I establish that a rapid transition is optimal if the persistence effect is relatively strong, and determine the path of taxes or subsidies that implements this transition, both when goods are produced competitively and when they are produced by monopolists. To explore the quantitative implications of the model I consider the introduction of a 10 percent charge on a subset of goods. I find that consumption adjusts inefficiently fast; implementing first-best adjustment requires a transitory discount of up to 60 percent of the cost increase.
Keywords: habit formation, projection bias, consumption shifts, optimal taxation
JEL Classification: D11, D62, H21, H23
Suggested Citation: Suggested Citation