13 Jul 2012Working Paper Summaries

De Gustibus non est Taxandum: Theory and Evidence on Preference Heterogeneity and Redistribution

by Benjamin Lockwood and Matthew Weinzierl

Individuals differ in the value they place on consumption relative to leisure. These preference differences help explain why some earn more than others, and they are a central part of popular and scholarly debates over taxation. In this paper, Benjamin Lockwood and Matthew Weinzierl show that variation in these preferences may also help explain why the extent of redistribution varies across countries and US states, and why (at least in the case of the United States) redistribution is weaker than conventional theory would suggest. More generally, Lockwood and Weinzierl argue that neglecting the role of preferences substantially impairs our understanding of both optimal and existing tax policy. Overall, findings suggest that this paper's generalized normative optimal tax model may be a better guide to policy advice than the conventional one. Key concepts include:

A proper understanding of the role of preference differences improves our ability not only to design taxation but also to understand existing tax policies.
Surprisingly, preference differences are absent from conventional optimal tax theory. That theory, instead, attributes all variation in earnings to differences in income-earning ability.
More variance in reported preferences is significantly associated with less redistribution across both countries and US states, conditional on observed variation in incomes and the correlation of income with preferences.

Author Abstract

Preferences over consumption and leisure play no role in the standard optimal tax model, which attributes all variation in earnings to differences in income-earning ability. We show how to incorporate these preferences, which like ability are publicly unobservable, into the standard model in a tractable way. In this more general model, the policy designer must guess at the relative importance of ability and preferences in explaining variation in earnings. We show that such preferences could, in principle, increase or decrease optimal redistribution. In the most plausible specifications of the model, however, the result is clear: greater variation in preferences lowers the optimal extent of redistribution. To generate more redistribution than in standard results, one must assume that the desire for income is inversely related to income earned. This result holds even when the conventional model accurately describes the average individual, and it suggests one potential resolution to the puzzle of why observed redistribution is in some cases weaker than conventional theory would suggest. We then establish a new empirical finding that confirms this model's central policy prediction across developed countries and U.S. states. In countries and states with more heterogeneous tastes for consumption relative to leisure, redistribution is statistically significantly lower.