Pawns and Queens Revisited: Public Provision of Private Goods when Individuals make Mistakes

This paper analyses the optimal tax policy and public provision of private goods when individuals differ in two respects: income-earning ability and rationality. Publicly provided goods should be overprovided or subsidised, relative to the decentralised optimum, if society’s marginal valuation of them exceeds the individual valuation and if these goods help relax the self-selection constraints, formulated in a new way. Optimal marginal income tax rates are shown to differ from the standard rules if publicly provided goods and labour supply are related.