Environmental Externalities and Consumer's Frames of Reference

Type:

SIEPR Discussion Paper 00-010

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Published:

11/1/00

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Abstract:

This paper addresses the design and impact of an optimal tax program in the presence of an environmental externality. In particular, it considers that an individual’s well-being depends strongly on one’s particular frames of reference. Two frames are looked at: individual consumption relative to the average (status) and the household’s own consumption history (habits). In the context of an overlapping generations economy, it is shown that a tax program not considering status seeking, but which is otherwise optimal, generally leads to too high aggregate consumption and too low environmental quality compared to a social optimum. However, habit formation generally lowers the difference between the allocation that is implied by this tax program and the social optimum.