Optimal Taxation with Behavioral Agents∗

This paper develops a theory of optimal taxation with behavioral agents. We use a general behavioral framework that encompasses a wide range of behavioral biases such as misperceptions, internalities and mental accounting. We revisit the three pillars of optimal taxation: Ramsey (linear commodity taxation to raise revenues and redistribute), Pigou (linear commodity taxation to correct externalities) and Mirrlees (nonlinear income taxation). We show how the canonical optimal tax formulas are modified and lead to a rich set of novel economic insights. We also show how to incorporate nudges in the optimal taxation frameworks, and jointly characterize optimal taxes and nudges. We explore the Diamond-Mirrlees productive efficiency result and the Atkinson-Stiglitz uniform commodity taxation proposition, and find that they are more likely to fail with behavioral agents. (JEL: D03, H21). ∗[email protected], [email protected]. For very good research assistance we thank Deepal Basak and Chenxi Wang, and for helpful comments we thank seminar participants at Berkeley, BEAM, BRIC, Brown, BU, Chicago, Columbia, NBER, NYU, PSE, Stanford, the UCL conference on behavioral theory, and H. Allcott, R. Chetty, S. Dellavigna, A. Frankel, M. Gentzkow, E. Glaeser, O. Hart, E. Kamenica, W. Kopczuk, D. Laibson, U. Malmendier, E. Saez, B. Salanié, J. Schwarzstein, A. Shleifer, and T. Stralezcki. Gabaix thanks INET and the NSF (SES-1325181) for support.