Optimal Nonlinear Income Taxation with Habit Formation∗

It has recently been shown that incorporating “keeping up with the Joneses”preferences into a prototypical two-ability-type optimal nonlinear income tax model leads to higher marginal tax rates for both types of agents. In particular, the high-skill type faces a positive marginal tax rate, rather than zero as in the conventional case. In this paper, agents’utility functions are postulated to exhibit “habit formation in consumption”such that the prototypical two-ability-type optimal nonlinear income tax model becomes a dynamic analytical framework. We show that if the government can commit to its future fiscal policy, the presence of consumption habits does not affect the standard results on optimal marginal tax rates. By contrast, if the government cannot pre-commit, the high-skill type will face a negative marginal tax rate, while the low-skill type’s marginal tax rate remains positive.