Optimal Taxation Policy in the Presence of Comprehensive Reference Externalities

Abstract

The author develops a model of optimal taxation in the presence of consumption and labor supply references, which extends the model of Ljungqvist and Uhlig (2000). The paper shows that under the assumed ‘keeping up with the Joneses’ style peer-group effects, in both consumption and labor supply, optimal tax on capital remains negative. However, with respect to the optimal labor tax, the first-best policy requires positive or negative labor income taxation depending on the strength of referencing in consumption, relative to the strength of referencing in labor, as well as other parameters of the model. This result extends Guo (2003) conclusions. In terms of fiscal policy prescriptions, the author shows that the presence of combined referencing effects in consumption and labor supply, as opposed to the referencing in consumption alone, reduces the scope of the Keynesian intervention.