Optimal Nonlinear Income Taxation with Habit Formation

Jang-Ting Guo and Alan Krause ()
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Alan Krause: Department of Economics, University of York

No 200810, Working Papers from University of California at Riverside, Department of Economics

Abstract: It has recently been shown that incorporating "keeping up with the Joneses" preferences into a prototypical two-ability-type optimal nonlinear taxation model leads to higher marginal income tax rates for both types of agents. Specifically, the high-skill type faces a positive marginal income tax rate, rather than zero as in the conventional case. In this paper, agents' utility functions are postulated to exhibit "habit formation in consumption" such that the prototypical two-ability-type optimal nonlinear taxation model becomes a dynamic analytical framework. We show that if the government can commit to its future fiscal policy, the presence of consumption habits does not affect the standard results on optimal marginal income tax rates. By contrast, if the government cannot pre-commit, the high-skill type will face a negative marginal income tax rate, whereas the effect of habit formation on the low-skill type's marginal tax rate is ambiguous.

Keywords: Income Taxation; Habit Formation; Commitment (search for similar items in EconPapers)
JEL-codes: H21 H24 (search for similar items in EconPapers)
Pages: 22 pages
Date: 2008-08, Revised 2008-08
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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https://economics.ucr.edu/papers/papers08/08-10.pdf First version, 2008 (application/pdf)

Related works:
Journal Article: Optimal Nonlinear Income Taxation with Habit Formation (2011)
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