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ESSAYS IN OPTIMAL

GOVERNMENT POLICY

c© Aart Gerritsen, 2014

ISBN: 978 90 361 0381 7

Cover design: Crasborn Graphic Designers bno, Valkenburg a.d. Geul

This book is no. 577 of the Tinbergen Institute Research Series, established through cooperation between Thela Thesis and the Tinbergen Institute. A list of books which already appeared in the series can be found in the back.

ESSAYS IN OPTIMAL GOVERNMENT POLICY

Essays over optimaal overheidsbeleid

PROEFSCHRIFT

ter verkrijging van de graad van doctor aan de Erasmus Universiteit Rotterdam

op gezag van de rector magnificus

Prof.dr. H.A.P. Pols

en volgens besluit van het College voor Promoties.

De openbare verdediging zal plaatsvinden op

vrijdag 21 februari 2014 om 9:30 uur

door

Adrianus Anthonius Franciscus Gerritsen geboren te Utrecht

Promotiecommissie

Promotor: Prof.dr. B. Jacobs

Overige leden: Prof.dr. A.J. Dur

Prof.dr. R.W. Boadway

Prof.dr. F. van der Ploeg

Aan mijn ouders

Adrianus (Adrie) Wilhelmus Gerritsen

Elisabeth (Bets) Francisca Gerritsen-Van Amerongen

Preface

Being a Ph.D. student has had a profound impact on my life, an impact that

can hardly be overstated. It allowed me to learn more about economics, public

finance, policy making, and political philosophy than I did in the preceding twenty

three years combined. It provided me with a framework to analyze issues of an

economic or moral nature, enabling me to think and form judgments critically and

independently. In short, it allowed me to grow up intellectually. I am fully aware

of how privileged I am for having been granted such opportunity, and am grateful

beyond words to those who enabled it.

First and foremost, I owe a large debt of gratitude to Bas Jacobs, my supervisor.

The way in which he welcomed me as part of his intellectual family has truly been

heartwarming. Indeed, the term ‘family’ is hardly an exaggeration. His devotion

to my academic development has been of an intensity and a selflessness commonly

only observed among families. He invested his time and effort not just in improving

my thesis, but in fostering a personal relationship that made collaboration with

him a real pleasure. He had faith in me during times in which I had very little left

of it myself, and whenever I was convinced a ceiling had been reached, he always

managed to stimulate me to carry my work to a higher level. I could not have

wished for a better or more involved supervisor.

I am happy to have had Ruud de Mooij as a second supervisor during the first

year of my Ph.D., before he left for the IMF. I look back with fond memories to

many coffees, lunches, and dinners I shared with him and Bas, and it is always a

great pleasure to see Ruud at any of the international conferences or in Washington,

D.C.

Ever since my first international conference, the 2010 meeting of the Canadian

Public Economics Group in Quebec City, Robin Boadway has been, for me, the

personification of the international community of public economists that greatly

enhanced my experience as a Ph.D. student. I am therefore very excited and

thankful that he agreed to be a member of my doctoral committee. I also very

much appreciate the fact that Robert Dur, Rick van der Ploeg, Otto Swank, and

Coen Teulings are willing to invest their scarce time in reading my dissertation

and being members of my committee.

Four years would have been a long time to survive without income. I therefore

thank The Netherlands Organization for Scientific Research, which provided the

financial support for my Ph.D. project under NWO Vidi Grant 452-07-013. I’m

grateful to the support staffs of the Tinbergen Institute and the Economics depart-

ment at the Erasmus University Rotterdam, that made sure my Ph.D. project ran

smoothly despite my own disorganized mind. Without diminishing the gratitude I

owe to the rest, I especially want to mention Carolien Stolting (TI) and Milky Vi-

ola Gonzalez (EUR) for their help with getting my thesis published and defended,

and Judith van Kronenberg (TI), whose unfailing cheerfulness is instrumental in

making the Tinbergen Institute such a great place to work.

I consider myself extremely lucky for having had Floris Zoutman and Hendrik

Vrijburg around me at the Erasmus University. While I knew Floris from my

time as a Master student in Groningen, we had not been in touch for a year until

happy coincidence brought us back together as office mates. It was thrilling to

see how little effect time had had on the fervor, the excitement, the depth of our

discussions. Floris is also the direct cause of my biggest disappointment during my

period as a Ph.D. student: I vowed to use our four years as office mates to teach

him an appreciation of Bob Dylan, at which I miserably failed. Neither did we

succeed in building that fort of empty coffee boxes, despite a no less than heroic

attempt. On the upside, together we did manage to solve any problem we set our

mind to, as long as there was a white board around.

Being two years ahead, Hendrik has always been an important example to me. I

greatly admire how he manages to soberly maintain his extraordinary involvement

in everything he does, whether it concerns his research or teaching, his family

including two young sons, or our common quest of discovering the most shady bar

around any of the conference venues we visit. I have grown especially attached

to our many coffees and lunches together, which never fail to provide either new

insights or higher-order confusion regarding whatever topic that happens to be

on the table. If the position of benevolent dictator ever becomes vacant, I would

happily recommend both Floris and Hendrik.

During the final months of my Ph.D., Uwe Thuemmel and Alexandra Rusu

joined the Erasmus University as the latest scions of tree Jacobs. I would like to

wish them both all the best in their academic career. I am looking forward to

seeing them more often in the years to come.

I am grateful to Jacques Siegers, of whom I was a research assistant during my

time as a Bachelor student in Utrecht. I still fret at the idea of what I would have

done without his encouragement when I faced a temporary spell of severe disil-

lusionment with economics. Jacques frequently mentioned that the chief purpose

of granting me a research assistantship was to stimulate my interest in economics

and academic scholarship. I hope he agrees that this purpose has been served well.

My dissertation is dedicated to my parents who, from my earliest memories on,

have stimulated my pursuit of knowledge. It was they, who taught me to read and

write long before school would. It was they, who tirelessly tutored me whenever I

had difficulties with a subject at school. It was they, who stimulated me to read,

and read, and read. And, most importantly, it was they, who instilled in me an

appreciation and respect for knowledge, the good, and the beautiful. I am also

thankful to my brothers, Willem, Dirk and Tom, who helped me drown any of the

superfluous brain cells that my parents provided me with.

My dear Bahar. More than anyone else, you know the highs and the lows I

experienced for my Ph.D. What is more, you were always there to sit them through

with me. When things went well, you shared in my excitement. When I felt dis-

couraged, you would lift my spirits. I hope you know how grateful I am for your

support – it is essential to everything I do.

Aart Gerritsen

München, Winter 2013/2014

‘It came into him life; it went out from him truth. It came to him short-lived actions; it went out from him immortal thoughts. It came to him business; it went from him poetry. It was dead fact; now, it is quick thought. It can stand, and it can go. It now endures, it now flies, it now inspires. Precisely in proportion to the depth of mind from which it issued, so high does it soar, so long does it sing.’

Ralph Waldo Emerson

Contents

Preface vii

1 Introduction and summary 1

2 Optimal taxation when people do not maximize well-being 15

2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

2.2 Optimal linear income taxation . . . . . . . . . . . . . . . . . . . . 20

2.3 Optimal non-linear taxation . . . . . . . . . . . . . . . . . . . . . . 26

2.4 The tax treatment of discrete decisions . . . . . . . . . . . . . . . . 31

2.5 How far away from their bliss point are people? . . . . . . . . . . . 35

2.6 Robustness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

2.7 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

3 Minimum wages and taxation in competitive labor markets with

endogenous skill formation 51

3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

3.2 Related literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

3.3 Model . . . . .