Component-Specific Versus Comprehensive Habits in a Model of Income and Consumption Taxation

Abstract

This paper proposes a model of economy with weakly non-separable preferences for both work effort and consumption. Households who derive utility from consumption of a single commodity and leisure take into account the habitual dependency of their utility on both labour supply and consumption in the past. As a result, this model provides an analysis of the effects of labour income and consumption taxes increase on asset holdings, consumption and labour supply of households. The model of comprehensive habits is contrasted by the standard habits in consumption model that is extended to include endogenous labour supply decisions. We show that one of the main results of the model includes the possibility for using comprehensive habits to capture the simultaneous time persistency in the behaviour of both consumption and leisure demand. The model also yields results in capturing the possibility for either co-movement or counter-movement of the main choice variables in response to the exogenous tax policy change.