Optimal taxation in the presence of income-dependent relative income effects

Unlike neoclassical economics in which humans are typically described as self-interested, more and more social studies strongly support the notion that individuals derive utility not only from their own status, but also from comparisons with others. While prior studies have shown that relative income effects matter for optimal income taxation, most assumed either homogeneous relative income effects for the entire population, or relative income effects that differ only on the basis of whether one is above or below their comparison group. We investigate the importance of relative income effects within the context of an optimal income tax model with a broader form of heterogeneity. Specifically, we assume income-dependent relative income effects, which follow in the spirit of empirical evidence. Simulation results show that the optimal tax system becomes more progressive to the extent that the relatively wealthy have stronger concerns regarding others’ income than the relatively poor. This is an important result because it may provide theoretical evidence that increasing progressivity can be efficiency-enhancing.