DP6776 Habit Formation and Labour Supply

Author(s): Helmuth Cremer, Philippe De Donder, DarĂ­o Maldonado, Pierre Pestieau
Publication Date: April 2008
Keyword(s): Habit formation, Myopia, Unretiring
JEL(s): D91, H21, H55
Programme Areas: Public Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6776

This paper shows that the combination of habit formation - present consumption creating additional consumption needs in the future - and myopia may explain why some retirees are forced to 'unretire', i.e., unexpectedly return to work. It also shows that when myopia about habit formation leads to unretirement there is a case for government's intervention. In a first-best setting the optimal solution can be decentralized by a simple 'Pigouvian' (paternalistic) consumption tax (along with suitable lump-sum taxes). In a second-best setting, when personalized lump-sum transfers are not available, consumption taxes may have conflicting paternalistic and redistributive effects. We study the design of consumption taxes in such a setting when myopic individuals differ in productivity.