Positional Concerns with Multiple Reference Points: Optimal Income Taxation and Public Goods in an OLG Model

Abstract

This paper concerns optimal income taxation and provision of a state-variable public good under asymmetric information in a two-type overlapping generations model, where people care about their relative consumption. Each individual may compare his/her own current consumption with his/her own past consumption as well as with other people’s current and past consumption. The appearance of positional concerns affects the policy choices via two channels: (i) the size of the average degree of positionality and (ii) positionality differences between the (mimicked) low-ability type and the mimicker. Under plausible empirical estimates, the marginal labor income tax rates become substantially larger, and the absolute value of the marginal capital income tax rate of the low-ability type becomes substantially smaller, compared to the conventional optimal income tax model. The extent by which the rule for public provision should be modified depends crucially on the preference elicitation format.