Optimal Income Taxation with Present Bias

Abstract

Work often entails up-front effort costs in exchange for delayed benefits, and mounting evidence documents present bias over effort in the face of such delays. This paper studies the implications for the optimal income tax. Optimal tax rates are computed for present-biased workers who choose multiple dimensions of labor effort, some of which occur prior to compensation. Present bias reduces optimal tax rates, with a larger effect when the elasticity of taxable income is high. Optimal marginal tax rates may be negative at low incomes, providing an alternative, corrective rationale for work subsidies like the Earned Income Tax Credit. (JEL D91, H21, H24)