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Optimal taxation in a habit formation economy

Sebastian Koehne and Moritz Kuhn

Journal of Public Economics, 2015, vol. 122, issue C, 31-39

Abstract: This paper studies habit formation in consumption preferences in a dynamic Mirrlees economy. We derive optimal labor and savings wedges based on a recursive approach. We show that habit formation creates a motive for subsidizing labor supply and savings. In particular, habit formation invalidates the well-known “no distortion at the top” result. We demonstrate that the theoretical findings are quantitatively important: in a parametrized life-cycle model, average labor and savings wedges fall by more than one-third compared with the case of time-separable preferences.

Keywords: Optimal taxation; Habit formation; Recursive contracts (search for similar items in EconPapers)
JEL-codes: D82 E21 H21 (search for similar items in EconPapers)
Date: 2015
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DOI: 10.1016/j.jpubeco.2014.12.007

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