CER-ETH – Center of Economic Research at ETH Zurich The Efficiency Consequences of Heterogeneous Behavioral Responses to Energy Fiscal Policies

ing from the gap between decision and experienced utility, we find that behavioral biases do not impose additional costs on welfare. This interpretation is consistent with the concept of internality proposed by Allcott et al. (2014) and the model of behavioral biases proposed by Farhi and Gabaix (2015). In contrast, we represent transaction cost microfrictions as an economic cost C that the consumer must bear to respond (denoted R = 1) to the policy I. Consumer k then faces the following decision problem: max R={0,1} (1−R) · [ max j Vkj − ηk(Pj + P e · Ej) ] +R · [ max j Vkj − ηk(Pj + P e · Ej + I)− C ] In this decision problem, if the consumer does not pay C, then she will optimize as if the policy I was not present. If she takes up the policy, then her welfare will change by the amount −ηkI −C.7 3.3. Optimal Pigouvian Instruments Let us now turn to the subset of fiscal instruments I that price negative externalities—that is, a Pigouvian tax. Let φ represent the marginal external cost of energy. In our framework, consumers must pay (P e + τ)Ej for operating technology j in the presence of tax τ . If consumers face microfrictions in computing the energy costs inclusive of the tax, we can derive an expression for the optimal Pigouvian tax. 7Chetty et al. (2007) propose a similar model to model boundedly rational agents that do not take into account a small tax. They refer to the cost C as a small cognitive cost. The difference in our framework is that we consider that C is a tangible economic cost that must be accounted for in social welfare. 11 Proposition 1. If microfrictions are transaction costs, Pigou holds that τ = φ. If microfrictions are behavioral biases represented by m, the bias-adjusted Pigouvian tax is (3) τ = φ m + P e · (1−m) m All proofs are in Appendix A. There is thus a stark difference in the level of the Pigouvian tax that must be charged whether microfrictions are considered tangible economic costs or behavioral biases. In the presence of behavioral biases, the expression for the optimal Pigouvian tax departs from the classic result in two ways because it aims to internalize both the externality and the behavioral biases. The marginal external cost is thus scaled by the size of the bias.8 If consumers’ biases with respect to energy costs lead to an undervaluation (i.e., m < 1), the tax must be adjusted upward, and vice versa. The price of energy also enters the expression because with a price-inclusive tax, the gap between decision and experienced utility is a function of not only the tax, but also the price of energy. Therefore, the adjustment could be quite large even for a modest level of m, and, as pointed out by Allcott et al. (2014), it could be optimal to levy a tax when the marginal external cost is zero. If there are additional fiscal instruments that impact the purchase decision, this will also impact the expression for the optimal tax. To illustrate, consider that an ad valorem sales tax, denoted T s, is levied on the price of each technology, and consumers’ response to T s is scaled by d, which may capture the lack of tax salience or other biases. The expression for the bias-adjusted Pigouvian tax then becomes (4) τ = φ m + P e · (1−m) m − T s · d m · ∑