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Optimal Nonlinear Income Taxation with Habit Formation

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  • Jang-Ting Guo

    ()
    (Department of Economics, University of California Riverside)

  • Alan Krause

    ()
    (Department of Economics, University of York)

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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File Function: First version, 2008
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Bibliographic Info

Paper provided by University of California at Riverside, Department of Economics in its series Working Papers with number 200810.

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Length: 22 pages
Date of creation: Aug 2008
Date of revision: Aug 2008
Handle: RePEc:ucr:wpaper:200810

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Related research

Keywords: Income Taxation; Habit Formation; Commitment;

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References

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  1. Jody Overland & Christopher D. Carroll & David N. Weil, 2000. "Saving and Growth with Habit Formation," American Economic Review, American Economic Association, vol. 90(3), pages 341-355, June.
  2. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June.
  3. Oswald, Andrew J., 1983. "Altruism, jealousy and the theory of optimal non-linear taxation," Journal of Public Economics, Elsevier, vol. 20(1), pages 77-87, February.
  4. Jaime Alonso-Carrera & Jordi Caballe & Xavier Raurich, 2001. "Consumption Externalities, Habit Formation, and Equilibrium Efficiency," UFAE and IAE Working Papers 499.01, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC).
  5. Christopher D Carroll, 2000. "Solving Consumption Models with Multiplicative Habits," Economics Working Paper Archive 421, The Johns Hopkins University,Department of Economics.
  6. Hotz, V Joseph & Kydland, Finn E & Sedlacek, Guilherme L, 1988. "Intertemporal Preferences and Labor Supply," Econometrica, Econometric Society, vol. 56(2), pages 335-60, March.
  7. Marcus Berliant & John Ledyard, 2004. "Optimal Dynamic Nonlinear Income Taxes with No Commitment," Public Economics 0403004, EconWPA, revised 21 Jun 2005.
  8. Bill Dupor & Wen-Fang Liu, 2003. "Jealousy and Equilibrium Overconsumption," American Economic Review, American Economic Association, vol. 93(1), pages 423-428, March.
  9. 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.
  10. 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.
  11. Guesnerie,Roger, 1998. "A Contribution to the Pure Theory of Taxation," Cambridge Books, Cambridge University Press, number 9780521629560, April.
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Citations

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Cited by:
  1. Jang-Ting Guo & Alan Krause, . "Dynamic Nonlinear Income Taxation with Quasi-Hyperbolic Discounting and No Commitment," Discussion Papers 11/16, Department of Economics, University of York.
  2. 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.
  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. Alan Krause, 2012. "Optimal Savings Taxation when Individuals have Different CRRA Utility Functions," Discussion Papers 12/13, Department of Economics, University of York.
  5. Jang-Ting Guo & Alan Krause, 2010. "Optimal Dynamic Nonlinear Income Taxation under Loose Commitment," Discussion Papers 10/23, Department of Economics, University of York.
  6. 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.

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