Working Paper: NBER ID: w23980
Authors: Alex Rees-Jones; Dmitry Taubinsky
Abstract: A growing body of evidence suggests that psychological biases can lead different implementations of otherwise equivalent tax incentives to result in meaningfully different behaviors. We argue that in the presence of such failures of “implementation invariance,” decoupling the question of optimal feasible allocations from the tax system used to induce them—the “mechanism design approach” to tax analysis—cannot be the right approach to analyzing optimal tax systems. After reviewing the diverse psychologies that lead to failures of implementation invariance, we illustrate our argument by formally deriving three basic lessons that arise in the presence of these biases. First, the mechanism design approach neither estimates nor bounds the welfare computed under psychologically realistic assumptions about individuals' responses to the tax instruments used in practice. Second, the optimal allocations from abstract mechanisms may not be implementable with concrete tax policies, and vice-versa. Third, the integration of these biases may mitigate the importance of information asymmetries, resulting in optimal tax formulas more closely approximated by classical Ramsey results. We conclude by proposing that a “behavioral” extension of the “sufficient statistics” approach is a more fruitful way forward in the presence of such psychological biases.
Keywords: Taxation; Psychological Biases; Optimal Tax Systems; Behavioral Economics
JEL Codes: D03; D6; H0; H2; H21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| psychological biases (D91) | violations of implementation invariance (P37) |
| psychological biases (D91) | complications in analysis of optimal tax systems (H21) |
| psychological biases (D91) | failure in estimating welfare under realistic assumptions (D69) |
| confusion and heuristic use (D80) | distortion of taxpayer responses to tax incentives (H31) |
| psychological biases (D91) | disconnect between theoretical models and practical applications (C67) |
| integration of biases (D91) | mitigation of significance of information asymmetries (D82) |
| optimal tax formulas (H21) | resemblance to classical Ramsey results (C62) |
| psychological biases (D91) | impact on taxpayer behavior and decision-making processes (H31) |