Subjective well-being, consumption comparisons, and optimal income taxation

Abstract

We introduce reference consumption into the standard utility function from optimal tax analysis. Individuals compare their consumption “narrowly” with those of the same productivity, or “broadly” with the average consumption across society. In both narrow and broad equilibria reference consumption is an increasing function of the tax parameters, so generating new theoretical results. Individual well-being decreases with the net wage (net-of-tax) rate for low productivity workers under narrow (broad) comparisons, thus adjusting redistributive taxation considerations. Further, in both cases reference consumption distorts labor supply away from the social optimum level, giving a distortion-correcting role for taxation.