O’Donoghue and Rabin (2003) on Paternalism and Sin Taxes

Ted O’Donoghue and Matthew Rabin, “Studying Optimal Paternalism, Illustrated by a Model of Sin Taxes." American Economic Review 93(2): 186-191, May 2003.

• “Economists will and should be ignored if we continue to insist that it is axiomatic that constantly trading stocks or accumulating consumer debt or becoming a heroin addict must be optimal for the people doing these things merely because they have chosen to do it [page 186].” 

• In the quasi-hyperbolic utility function, Beta < 1 implies a time-inconsistent preference for immediate gratification. In the welfare (efficiency) analysis, this preference for immediate gratification is treated as an error. That is, society sides with the long-run Dr. Jekyll, not the impatient short-run Mr. Hyde. 

• In the model, potato chips have present benefits but future costs. The quasi-hyperbolic decision maker, or at least the Mr. Hyde component of that decision maker, undervalues those future costs. 

• What is the most efficient way for the government to raise (a given amount of) revenue through taxes on the two goods, carrots and potato chips? If there were no present bias, both goods should be taxed equally. But if some consumers display present bias, efficiency suggests taxing the tempting good, potato chips, at significantly higher rates. 

• High taxes on potato chips do not harm fully “rational” consumers much, but help present-biased people significantly by internalizing the “internality.” 

• Offering commitment options to sophisticated present-biased people could help them, with little or no cost to those who are not biased. (A sophisticated present-biased person is someone who understands that she is present biased, and hence might be willing to pre-commit in such a way as to restrain her future choices.)

• More generally, policy might want to take into account the possibility of less-than-rational behavior. Some policies that might be valuable include mandatory cooling-off periods, required information disclosure, and careful selection of default options.