This paper analyzes the pattern of consumption taxes in a two-period model with habit formation and myopia. An individual’s second-period needs increase with first period consumption. However, myopic individuals do not see this habit formation relation when they take their saving decision. The first-best solution is 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. Taxes should discourage consumption of goods that entail negative externalities (unforeseen habits), but instead they discourage less the consumption of goods that are proportionately consumed by individuals with high net social marginal utility of income. Both myopic and farsighted individuals may benefit more from the second-best policy as the proportion of myopic agents in society increases.
