Optimal fiscal policy in a model with inherited aspirations and habit formation

• Author: Carlos Miguel,Stéphane Bouché
• Date: 01 December 2019
• Published date: 01 December 2019
• DOI: http://doi.org/10.1111/jpet.12385

J Public Econ Theory. 2019;21:1309–1331. wileyonlinelibrary.com/journal/jpet © 2019 Wiley Periodicals, Inc.

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Received: 16 October 2018

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Revised: 27 February 2019

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Accepted: 29 May 2019

DOI: 10.1111/jpet.12385

ORIGINAL ARTICLE

Optimal fiscal policy in a model with inherited

aspirations and habit formation

Stéphane Bouché

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Carlos De Miguel

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1

Facultad de Ciencias Económicas y

Empresariales, Universidad de Vigo,

ECOBAS and RGEA, Vigo, Spain

2

Facultad de Ciencias Económicas y

Empresariales, Universidad de Vigo and

REDE, Vigo, Spain

Correspondance

Carlos de Miguel, Facultad de Ciencias

Económicas y Empresariales,

Universidad de Vigo, Campus as Lagoas‐

Marcosende, 36310 Vigo, Spain.

Email: cmiguel@uvigo.es

Funding information

Government of Spain and European

Regional Development Fund, Grant/

Award Number: RTI2018‐093365‐B‐100

Abstract

In this paper, we analyze optimal fiscal policies in an

overlapping generations framework, where preferences

exhibit aspirations in consumption and environmental

quality as well as habit formation. We focus on the second

best policies when the government needs to finance a

given stream of public expenditures by using distortionary

taxes. We derive necessary and sufficient conditions under

which the competitive equilibrium is characterized by

levels of capital and environmental quality that are too

small and a level of labor supply that is too large. Our

numerical simulations show that an optimal fiscal policy

can be used as an effective stabilization device and that

when consumption taxes are fixed, the planner imple-

ments maintenance investment and capital income sub-

sidies while financing public spending through labor and

fixed consumption taxes.

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INTRODUCTION

The present paper focuses on the influence of inherited aspirations and habit formation

concerning the design of optimal fiscal policies when the government needs to finance public

expenditures through distortionary taxation. The inherited nature of the aspiration process

requires some sort of intergenerational linkage and justifies the use of the overlapping

generations (OLGs) framework. While aspirations are inherited from the previous generation

and constitute an external benchmark, habit formation is a comparison mechanism that only

depends on the private agent. Both elements are used as a frame of reference to evaluate utility

gains and imply that agents value the perceived increase in the variables that exhibit aspirations

or habits and not just their absolute level. In our framework, the short‐lived individuals will not

internalize the long‐term impact of their decisions that will give rise to the aspirations of the

following generation. Concerning the variables that will be affected by aspirations, we have

chosen to focus on consumption and environmental quality. Aspirations in consumption have

already been introduced in the Diamond framework (see, e.g., Artige, Camacho, & De La Croix,

2004; Alonso‐Carrera, Caballe, & Raurich, 2007; de la Croix, 1996; de la Croix & Michel, 1999)

but none of these studies has focused on the second best policies when the government needs to

finance public expenditures. A notable exception is the work of Aronsson and Johansson‐

Stenman (2014) in which the authors study the optimal provision of state variable public goods

(global climate being the prime example) in a model where people care about relative

consumption (including aspirations). We have chosen environmental quality as our second

variable since the latter is commonly used as an intergenerational externality where future

generations bear the costs imposed by current ones (see, e.g., Bovenberg & Heijdra, 1998; John

& Pecchenino, 1994; Ono, 1996). Models introducing environmental aspirations are not

common and we are only aware of the paper by Schumacher and Zou (2008) where agents

experience aspirations in pollution and the authors study the complex dynamic implications of

this assumption. Habit formation will in turn affect old‐age consumption which is standard in

two period OLG models (see, e.g., Alonso‐Carrera et al., 2007; Lahiri & Puhakka, 1998;

Wendner, 2002).

The concepts of aspirations and habit formation are related to the one of relative well‐being

whose importance has been highlighted in several empirical papers, such as Clark and Oswald

(1996) or Ferrer‐i‐Carbonell (2005) among others. The main conclusion being that utility does

not only depend on levels but also on some reference points which are used in welfare

evaluations. Concerning more specifically aspirations, Becker (1992) has noted that individual

behavior is affected by aspirations acquired as a child generating the intergenerational transfer

of tastes. For example, Waldkirch, Ng, and Cox (2004) estimate that parental preferences

explain between 5% and 10% of the preferences of their children after controlling for their

respective incomes. Senik (2009) presents evidence showing that an individual’s well‐being

increases if he has done better in life than his parents. This large empirical evidence combined

with the important role that endogenous preferences can play concerning environmental issues

(see, e.g., Brekke & Howarth, 2003; Welsch, 2009) leads us to include consumption and

environmental aspirations in our framework. A large number of empirical studies also suggest

that the satisfaction derived from present decisions is affected by choices made in the past

(Carrasco, Labeaga, & DavidLópez‐Salido, 2005; de la Croix & Urbain, 1998). This empirical

evidence motivates the introduction of habit formation in the current framework.

Our work shares some common features with the literature focusing on the environmental

implications of consumption externalities developed by Wendner (2003, 2005), Brekke and

Howarth (2003), as well as Howarth (2006) among others. It is also related to models studying at

the same time environmental conservation and optimality. Most of these models focus on the

planner’s problem and on the method to decentralize the first best solution through an

appropriate tax policy while we focus on the second best policies. Notable exceptions in line

with our approach are the studies of Aronsson and Johansson‐Stenman (2014) as well as the

one of Nakabayashi (2010). The latter focuses on public sector efficiency in an OLG model with

environmental quality.

In the present paper, we focus on a model where agents live for three periods: During

childhood, the agent inherits consumption aspirations from his parents and does not take any

decisions. As an adult, the agent works, inherits environmental aspirations, and derives utility

from a consumption net of aspirations and from leisure. In old age, the agent retires and derives

utility from a consumption net of habits and an environmental quality net of aspirations. On the

production side, a representative firm produces output by combining capital and labor into a

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BOUCHÉ AND DE MIGUEL