Scandinavian Working Papers in Economics

Working Papers in Economics,
University of Gothenburg, Department of Economics

No 701: Too slow a change? Deep habits, consumption shifts and transitory tax

I.M. van den Bijgaart ()
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I.M. van den Bijgaart: Department of Economics, School of Business, Economics and Law, Göteborg University, Postal: P.O. Box 640, SE 40530 GÖTEBORG, Sweden

Abstract: This paper studies shifts in the consumption bundle when consumption is subject to habit formation, and consumers do not internalize this habit formation process. Habits are goodspecific, or ’deep’, and cause persistence in good-specific consumption. In addition, at the aggregate level, habits act as benchmark against which consumption is evaluated. I establish that a rapid transition is optimal if the persistence effect is relatively strong, and determine the path of taxes or subsidies that implements this transition, both when goods are produced competitively and when they are produced by monopolists. To explore the quantitative implications of the model I consider the introduction of a 10 percent charge on a subset of goods. I find that consumption adjusts inefficiently fast; implementing first-best adjustment requires a transitory discount of up to 60 percent of the cost increase.

Keywords: habit formation; projection bias; consumption shifts; optimal taxation

JEL-codes: D11; D62; H21; H23

52 pages, June 2017

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