Dynamic nonlinear income taxation with quasi-hyperbolic discounting and no commitment

Abstract

This paper examines a dynamic model of nonlinear income taxation in which the government cannot commit to its future tax policy, and individuals are quasi-hyperbolic discounters who cannot commit to future consumption plans. The government has both paternalistic and redistributive objectives, and therefore uses its taxation powers to maximize a utilitarian social welfare function that reflects individuals’ true (long-run) preferences. Under first-best taxation, quasi-hyperbolic discounting exerts no effect on the level of social welfare attainable. Under second-best taxation, quasi-hyperbolic discounting increases (resp. decreases) the level of social welfare attainable when separating (resp. pooling) taxation is optimal. In stark contrast to previous studies, this result implies that some individuals can actually be better-off in the long run as a result of their short-run impatience.