Temptation and Taxation

Abstract

We study optimal taxation when consumers have temptation and self-control problems. Embedding the class of preferences developed by Gul and Pesendorfer into a standard macroeconomic setting, we first prove, in a two-period model, that the optimal policy is to subsidize savings when consumers are tempted by “excessive” impatience. The savings subsidy improves welfare because it makes succumbing to temptation less attractive. We then study an economy with a long but finite horizon which nests as a special case the Phelps-Pollak-Laibson multiple-selves model (thereby providing guidance on how to evaluate welfare in this model). We prove that when period utility is logarithmic the optimal savings subsidies increase over time for any finite horizon. Moreover, as the horizon grows large, the optimal policy prescribes a constant subsidy, in contrast to the well-known Chamley-Judd result.

Keywords: consumption and saving, temptation, self-control, tax policy