Envy, Inequity Aversion, and Optimal Income Taxation

The paper analyzes the optimal income taxation policy when inequity aversion exists among taxpayers. The influence of inequity aversion on the optimal income tax scheme depends on whether taxpayers are concerned about inequality in wages or in rents (i.e., wages minus effort costs). If agents compare wages, then a more productive agent who is averse to inequity produces more output than the first-best level of output, while a less productive agent produces less than the second-best level of the output in a standard adverse-selection model. Therefore, the trade-off between efficiency and equity becomes more serious than the trade-off in a reference case without inequity aversion. Conversely, when agents' disutility from inequity arises from inequality in rents, the trade-off between efficiency and equity may become either more serious or milder than in the reference case.