Subjective well-being, peer comparisons and optimal income taxation

Abstract

Empirical evidence suggests that an important determinant of subjective well-being is how an individual’s consumption compares with that of their immediate peers. We introduce peer comparisons into the standard optimal tax framework and demonstrate that the optimal linear tax expression is adjusted in three key ways, the latter two of which are novel to this paper and act to lower the tax rate. First, the dependence of well-being on peer income introduces an externality that distorts labour supply above that which individuals would choose were they to recognise the interplay between their own choices and the Nash equilibrium level of peer consumption. The optimal tax rate is adjusted upwards to (partially) correct this distortion. Second, if individual labour supply is a function of peer consumption, there are ‘Keeping up with the Joneses’ multiplier effects that raise the Nash compensated labour supply elasticity above the individual labour supply elasticity. This implies a lower tax rate on efficiency grounds. Third, Nash indirect well-being is decreasing in the wage rate for workers with wages close to the reservation wage. To the extent that this lowers the covariance between gross earnings and the net social marginal value of income, this will act to lower the optimal tax rate.