Mirrlees meets Laibson: Optimal Income Taxation with Bounded Rationality

This paper studies an optimal taxation problem in a dynamic economy inhabited by individuals who differ in productivity (as in Kocherlakota, 2006) and in the short-term discount factor. We determine incentive compatible Pareto optimal allocations in a multidimensional screening model where individuals have to report truthfully their types. Moreover, we characterize the optimal non linear tax on capital and labor income that implements such allocations in a competitive equilibrium. Two forms of bounded rationality are considered: in the first one, some individuals discount future payoffs at a higher rate than others (myopia). In this application, the planner respects consumers' sovereignty, and maximizes a Paretian social welfare function. In the second application, some individuals are time inconsistent: they systematically change future plans and regret ex-post for the lack of commitment power. We show that the marginal tax on capital income implementing the optimal allocation consists of several elements, which combine incentive compatibility and bounded rationality considerations. The resulting optimal tax is a decreasing function of both the fraction of short-sighted individuals and the intensity of myopia/hyperbolic discounting. Our results are not driven by the paternalistic behavior of the planner, but by the incentive/self control problem and the necessity of providing the right incentive to high productive, far-sighted individuals. However, when the planner would like to push hyperbolic individuals toward the right consumption/saving path, we show that the optimal marginal tax includes also a paternalistic component that further decrease the optimal tax compared to the case with only exponential agents.