Tax policy with hyperbolic discounting

Abstract

This paper investigates the properties of taxation in the three-period overlapping generations model where individuals possess hyperbolic discounting preferences. Two key issues are addressed. First, the paper argues that a reform policy shifting a regime from income taxation to consumption taxation produces a positive welfare outcome at a marginal level. Second, it characterizes a consumption-tax scheme that could rectify the undersaving problem in hyperbolic individuals. The derivation of the scheme suggests the declining structure of tax rates on consumptions as individuals move towards elder age cohorts. Intuitively, this structure of consumption taxation will restrain the excessive consumptions in early lives of individuals. The numerical evidence appears to be in favor of this proposed scheme; i.e., from the simulations, the implementation of the scheme generates more consumption smoothing, thereby improving welfare of hyperbolic individuals.