Optimal Second-Best Taxation When Individuals Have Social Preferences

Models where people derive well-being from motives other than material self-interest – including those rooted in status concerns – are surprisingly scarce in the study of optimal redistributive taxation. In fact, despite extensive evidence from experimental research, other-regarding behavior driven by prosocial preferences is more or less absent in this literature. The purpose of the present paper is to start filling this gap by analyzing the implications of prosocial preferences related to equality and efficiency for optimal income taxation. In doing so, we take a broad perspective by examining three well-known models of social preferences developed by Fehr and Schmidt (1999), Bolton and Ockenfels (2000), and Charness and Rabin (2002), respectively. Our contribution is to analyze the implications of these three social preference models for optimal redistributive income taxation based on a discrete version of the Mirrleesian (1971) framework of optimal nonlinear income taxation. We find that social preferences may have a considerable impact on the structure of marginal income taxation, and that interactions between externality correction and redistributive aspects of taxation are likely to play an important role for the optimal tax structure.