Lump-sum tax or flat income tax? Welfare implications of taxation policy in the presence of social comparison

How should the government design a welfare-optimizing taxation policy in the scenario that individuals’ utility is reference-dependent, determined in part by comparison between others’ consumption and their own? Such socially reference-dependent utility tends to yield lower social welfare, since workers must increase their labor supply to support consumption which is partially ‘neutralized’ in their utility by the consumption of other members of society. By analyzing the government’s taxation policy in a general equilibrium framework, our model shows that while a non-distortionary (ie. lump-sum) tax preserves this intuitive result, an optimized flat-rate income tax generates a striking result in which consumer welfare can be in fact increasing in the intensity of social comparison as long as the intensity is not too high. By mitigating the workers’ incentive to over-work through the income-based tax, we show that the flat-rate income tax can outperform the lump-sum tax welfare-wise in the presence of social comparison, challenging the conventional wisdom on distortionary taxes. We also conduct comparisons between the two types of taxation policies in terms of public goods provision, labor supply and consumption. The findings provide insight on optimal taxation policy design under the realistic scenario that individuals in society have socially reference-dependent preferences.