Non-Pigouvian Tax Design with Fully Aware Agents
by
Mirta N. S. Bugarin
Department of Economics, University of Brasilia
Coauthors: Mauricio S. Bugarin (Department of Economics, University of Brasilia)

Abstract

  In the last few decades, macroeconomic models evolved to include precise forms of microeconomics foundations. In those richer models, aggregate identities emerge from a well-defined maximizing behavior of individual-level rational agents, generating deeper insights on the relationship between individual decisions, aggregate response to economic policies and the behavior of macroeconomic variables. However, the basic structure of many of those models consists of identical agents simultaneously solving similar problems, without considering (explicitly) the interdependence of each other’s decisions. Therefore, the representative agent hypothesis is usually not fully explored in those models, in the sense that agents are not completely aware of their representative role.

  A natural question that arises in this context is to which extent the results obtained in a representative-agent-type model are sensitive to this limited awareness assumption. Furthermore, one would like to determine what are the implications in the design of an optimal policy when that assumption is not neutral.

  The paper explores this issue in the context of a government who wants to establish an optimal taxation rule to cope with an industry-wide production externality. The model economy is based on a structure first analyzed in Sargent (1987). The awareness of the representative agent is introduced in two steps. First, it is assumed that a representative firm is aware of its own production externality as part of aggregate production, but is not aware of its representativeness. In this case the distortion caused by the externality may be solved by the traditional use of a Pigouvian tax, so that there is no real novelty. In fact, as expected in this case, the solution converges to Sargent’s as the number of firms tends to infinity.

  In the second step, the firm is assumed to be totally aware of its representative role when its optimization problem is solved. In this case a Pigovian tax is not necessary for there is an immediate internalization of the externality. However, this trivial no-tax policy is not robust to the situation where only a proportion of the total number of firms recognizes its representativeness. In this more complex situation of heterogeneous firms, an optimal signaling tax device is derived. This non-Pigouvian tax schedule solves the coordination problem that arises when firms are heterogeneous enabling to obtain an efficient equilibrium.

Date received: July 5, 2000

Copyright © 2000 by the author(s). The author(s) of this document and the organizers of the conference have granted their consent to include this abstract in Atlas Conferences Inc. Document # cafl-18.