Taxing Humans: Pitfalls of the Mechanism Design Approach and Potential Resolutions

35 Pages Posted: 30 Oct 2017 Last revised: 8 Nov 2017

See all articles by Alex Rees-Jones

Alex Rees-Jones

Cornell University - Department of Economics; National Bureau of Economic Research (NBER)

Dmitry Taubinsky

Harvard University

Date Written: October 2017

Abstract

A growing body of evidence suggests that psychological biases can lead different implementations of otherwise equivalent tax incentives to result in meaningfully different behaviors. We argue that in the presence of such failures of “implementation invariance,” decoupling the question of optimal feasible allocations from the tax system used to induce them—the “mechanism design approach” to tax analysis—cannot be the right approach to analyzing optimal tax systems. After reviewing the diverse psychologies that lead to failures of implementation invariance, we illustrate our argument by formally deriving three basic lessons that arise in the presence of these biases. First, the mechanism design approach neither estimates nor bounds the welfare computed under psychologically realistic assumptions about individuals' responses to the tax instruments used in practice. Second, the optimal allocations from abstract mechanisms may not be implementable with concrete tax policies, and vice-versa. Third, the integration of these biases may mitigate the importance of information asymmetries, resulting in optimal tax formulas more closely approximated by classical Ramsey results. We conclude by proposing that a “behavioral” extension of the “sufficient statistics” approach is a more fruitful way forward in the presence of such psychological biases.

Suggested Citation

Rees-Jones, Alex and Taubinsky, Dmitry, Taxing Humans: Pitfalls of the Mechanism Design Approach and Potential Resolutions (October 2017). NBER Working Paper No. w23980. Available at SSRN: https://ssrn.com/abstract=3061672

Alex Rees-Jones (Contact Author)

Cornell University - Department of Economics ( email )

Ithaca, NY 14853
United States

HOME PAGE: http://www.alexreesjones.com

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Dmitry Taubinsky

Harvard University ( email )

Cambridge, MA
United States

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