DP6776 Habit Formation and Labour Supply

Author(s): Helmuth Cremer , Philippe De Donder , Darío Maldonado , Pierre Pestieau

Publication Date: April 2008

Keyword(s): Habit formation , Myopia , Unretiring

JEL(s): D91 , H21 , H55

Programme Areas: Public Policy

Link to this Page: www.cepr.org/pubs/dps/DP6776.asp.asp

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.