Discussion paper

DP6776 Habit Formation and Labour Supply

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.

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Citation

Pestieau, P, H Cremer, P De Donder and D Maldonado (eds) (2008), “DP6776 Habit Formation and Labour Supply”, CEPR Press Discussion Paper No. 6776. https://cepr.org/publications/dp6776