Optimal Taxation When People Do Not Maximize Well-Being

Economists typically assume that a person’s behavior is aimed at maximizing his or her well-being. This assumption is increasingly subjected to criticism from both economists and psychologists. For example, labor-supply decisions are bound to be suboptimal if people have misperceptions about the income tax system or about their own preferences, or if they are constrained by firm-imposed restrictions on working hours.                                  

In this publication, Gerritsen shows how the income tax system could be adjusted to take into account suboptimal labor-supply decisions. Alongside the standard equity-versus-efficiency effects of taxation, he finds that taxes can play a useful role in correcting people’s suboptimal labor-supply decisions. To help correct suboptimal behavior, marginal taxes should be higher (lower) for individuals who work suboptimally much (little).

Gerritsen uses British survey data on people’s subjective life satisfaction to empirically test whether individuals work a suboptimal number of labor hours. He finds that low-income workers tend to work ‘too little’ and high-income workers ‘too much’. This provides a motive for lower marginal tax rates at the bottom and higher marginal tax rates at the top of the U.K. income distribution.

Published:   Journal of Public Economics, 2016, 144, pp. 122-139.