The temptation tax

Banerjee and Mullainathan offer a different
explanation, one which shows how temptation might interact in a unique
way with poverty. Suppose, they argue, that there are certain goods
that people are tempted by, such as candy, or coffee, or cigarettes.
Then suppose that as people get richer, they spend a decreasing
proportion of their income on these goods; not a smaller absolute amount, but a smaller proportion.
(There’s only so much money you’re likely to spend on cigarettes, no
matter how rich you get.) Finally, suppose you’re realistic enough to
know that you’ll be just as tempted in the future by these items as you
are today.

In sum, your “long term self” knows that you will
spend money on temptation goods in the future, but places no value on
that spending. (Your long term self doesn’t like the fact
that you’ll spend money on cigarettes, even though your today self
wants it.) Knowing that you will spend this money amounts to a
“temptation tax” on future wealth. This is a disincentive to save for
the future. Why save today? After all, your future self will just
squander the money on cigarettes!

But as you get wealthier, the effective “tax rate”
is lower, because temptation goods are a smaller proportion of your
income. With a lower tax rate, your disincentive to save shrinks.
Perversely, if you expect to be wealthier in the future, you have a
greater incentive to save and invest! Banerjee and Mullainathan show
that this can create a poverty trap. When you expect to be poor in the
future, you are less likely to save and invest, which keeps you in
poverty. When you expect to be wealthy in the future, you are more
likely to save and invest, which makes you wealthier still.

Here is the core article.  For the pointer I thank Rachel Strohm, who tweets about Africa and economic development.


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