Relativity, Inequality, And Optimal Nonlinear Income Taxation

How does concern for consumption relative to others (“relativity”) affect the structure of optimal nonlinear income taxation? Our article provides three sets of answers to this general question. First, it supports the conclusion in the literature that relativity leads to higher marginal tax rates. In doing so, it both generalizes some of the conditions under which this result is obtained in the literature and fleshes out the detailed structure for optimal marginal tax rates for specific functional forms for distribution, utility function, and social welfare function. Second, the article goes beyond the literature and examines the impact of relativity on the progression of optimal marginal tax rates. By and large, we find support for greater progressivity, defined as the steepness of the rise of the marginal tax rate schedule, as relativity concern increases. Third, none of the papers in the literature, to our knowledge, examines the interplay of relativity and inequality in determining the optimal structure of income taxes. Our special analytical cases and more general numerical calculations support the conclusion that higher inequality dampens the positive impact of greater relativity on the level and the progression of marginal tax rates. More work is needed to further explore this interaction between relativity and inequality that our analysis has uncovered.