New publication on optimal taxation for internalities
In a new study published in the prestigious journal American Economic Journal: Economic Policy (VWL Handelsblatt Rating A), Dr. Michael Kramm (TU Dortmund) and Dr. Andreas Gerster (University of Mannheim) investigate the optimal combination of taxation and product standards—such as minimum standards for energy consumption—to help consumers make better decisions in complex decision-making situations.
Numerous studies show that consumers often make decisions that are not in their best interest, whether by underestimating the harm of cigarettes or sugar or by misunderstanding and ignoring difficult-to-comprehend product attributes such as energy efficiency or hidden costs in insurance policies. These so-called internalities provide a rationale for taxes or product standards aimed at addressing such biases.
The newly published study demonstrates that consumer choices provide valuable information about individual biases. These biases can be targeted using nonlinear tax systems, allowing policymakers to address affected consumers more effectively. The authors develop a model that reduces the characteristics of optimal tax rates to a few key parameters, including the distribution of consumer utility and biases. This approach allows for the flexible design of tax rates based on product attributes (e.g., energy efficiency), thereby addressing the heterogeneity among consumers.
In addition to taxes, the authors propose attribute-based standards when biases are strongly negatively correlated with consumer utility—meaning when the preferences of policymakers and consumers diverge significantly. Standards are particularly useful when price mechanisms alone are insufficient to correct biases.
The authors extend existing theories on optimal taxation in the presence of behavioral biases. In particular, the combination of taxes and standards provides policymakers with a valuable tool for achieving welfare gains.
Using the example of the market for energy-efficient light bulbs, the study illustrates how optimal taxation for energy efficiency could look in practice. In this case, the combination of minimum standards and nonlinear taxes in the light bulb market leads to a significant increase in consumer welfare
Gerster, A., & Kramm, M. (2024). Optimal Internality Taxation of Product Attributes. American Economic Journal: Economic Policy, 16(3), 394–419. doi.org/10.1257/pol.20220416