Optimal Income Tax in the Presence of Status Effects

Abstract

The classical optimal income tax problem does not reveal many general properties except for the well-known tendency for marginal tax rates to reduce for high ability types, and in fact to become zero for the top type. The existence of distortions from individuals competing to attain social status by using consumption signals justifies some measure of income tax. The question posed here is whether it also constitutes a reason for a more progressive income tax schedule. The answer is found to be broadly negative if progressivity is interpreted as increasing marginal tax rates. On the other hand, status-seeking makes the optimal tax schedule steeper so that redistribution is increased. Broadly, the analysis of status-seeking based on a signalling approach confirms and strengthens the existing view of an optimal tax schedule.