Dynamic Nonlinear Income Taxation with Quasi-Hyperbolic Discounting and No Commitment

This paper examines a dynamic model of nonlinear income taxation in which the government cannot commit to its future tax policy, and individuals are quasi-hyperbolic discounters who cannot commit to future consumption plans. The government uses its taxation powers to maximise a utilitarian social welfare function which reflects individuals' true (long-run) preferences. Under first-best taxation, quasi-hyperbolic discounting has no effect on the level of social welfare attainable. Under second-best taxation, quasi-hyperbolic discounting increases (resp. decreases) the level of social welfare attainable when separating (resp. pooling) taxation is optimal. The effects of quasi-hyperbolic discounting on the optimal marginal tax rates applicable to labour and savings income are also explored.