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Optimal Nonlinear Income Taxation with Habit Formation

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  • JANG‐TING GUO
  • ALAN KRAUSE

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.

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Bibliographic Info

Article provided by Association for Public Economic Theory in its journal Journal of Public Economic Theory.

Volume (Year): 13 (2011)
Issue (Month): 3 (06)
Pages: 463-480

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Handle: RePEc:bla:jpbect:v:13:y:2011:i:3:p:463-480

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  1. Christopher D. Carroll & Jody Overland & David N. Weil, 1995. "Saving and growth with habit formation," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 95-42, Board of Governors of the Federal Reserve System (U.S.).
  2. Craig Brett & John Weymark, 2008. "Optimal Nonlinear Taxation of Income and Savings without Commitment," Vanderbilt University Department of Economics Working Papers 0805, Vanderbilt University Department of Economics.
  3. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 98(3), pages 519-43, June.
  4. Bill Dupor & Wen-Fang Liu, 2003. "Jealousy and Equilibrium Overconsumption," American Economic Review, American Economic Association, American Economic Association, vol. 93(1), pages 423-428, March.
  5. Marcus Berliant & John O. Ledyard, 2014. "Optimal Dynamic Nonlinear Income Taxes with No Commitment," Journal of Public Economic Theory, Association for Public Economic Theory, Association for Public Economic Theory, vol. 16(2), pages 196-221, 04.
  6. Christopher D Carroll, 2000. "Solving Consumption Models with Multiplicative Habits," Economics Working Paper Archive, The Johns Hopkins University,Department of Economics 421, The Johns Hopkins University,Department of Economics.
  7. Jaime Alonso-Carrera & Jordi Caballé & Xavier Raurich, 2004. "Consumption Externalities, Habit Formation and Equilibrium Efficiency," Scandinavian Journal of Economics, Wiley Blackwell, Wiley Blackwell, vol. 106(2), pages 231-251, 06.
  8. Jang-Ting Guo & Zuzana Janko, 2009. "Reexamination of Real Business Cycles in a Small Open Economy," Southern Economic Journal, Southern Economic Association, vol. 76(1), pages 165-182, July.
  9. Hotz, V Joseph & Kydland, Finn E & Sedlacek, Guilherme L, 1988. "Intertemporal Preferences and Labor Supply," Econometrica, Econometric Society, Econometric Society, vol. 56(2), pages 335-60, March.
  10. Guesnerie,Roger, 1998. "A Contribution to the Pure Theory of Taxation," Cambridge Books, Cambridge University Press, Cambridge University Press, number 9780521629560.
  11. Oswald, Andrew J., 1983. "Altruism, jealousy and the theory of optimal non-linear taxation," Journal of Public Economics, Elsevier, Elsevier, vol. 20(1), pages 77-87, February.
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Cited by:
  1. Alan Krause, 2012. "Optimal Savings Taxation when Individuals have Different CRRA Utility Functions," Discussion Papers, Department of Economics, University of York 12/13, Department of Economics, University of York.
  2. Jang-Ting Guo & Alan Krause, . "Dynamic Nonlinear Income Taxation with Quasi-Hyperbolic Discounting and No Commitment," Discussion Papers, Department of Economics, University of York 11/16, Department of Economics, University of York.
  3. Jang-Ting Guo & Alan Krause, 2010. "Dynamic Income Taxation without Commitment: Comparing Alternative Tax Systems," Working Papers 201005, University of California at Riverside, Department of Economics, revised Jun 2010.
  4. Shu-Hua Chen, 2012. "On the Growth and Stability Effects of Habit Formation and Durability in Consumption," Annals of Economics and Finance, Society for AEF, vol. 13(2), pages 283-298, November.
  5. Jang-Ting Guo & Alan Krause, 2010. "Optimal Nonlinear Taxation of Income and Education Expenditures," Working Papers 201008, University of California at Riverside, Department of Economics, revised Aug 2010.
  6. Jang-Ting Guo & Alan Krause, 2010. "Optimal Dynamic Nonlinear Income Taxation under Loose Commitment," Discussion Papers, Department of Economics, University of York 10/23, Department of Economics, University of York.

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