Signalling, Social Status and Labor Income Taxes

We investigate the effects of introducing a linear labor income tax under the assumptions that individuals have concerns for social status, that they can signal their relative standing by spending on a conspicuous good, and that the tax revenue is redistributed by means of lump sum transfers. We show that the way social status is defined – i.e. how relative standing is computed and evaluated – crucially affects the desirability of the tax policy. More precisely, if status is ordinal then a labor income tax can decrease waste in conspicuous consumption only if the distribution of pre-tax incomes (or earning potentials) is not too unequal. The same applies for the tax to induce a Pareto improvement, but with the bound on pre-tax inequality being smaller. Instead, if status is cardinal then neither requirement applies: for any degree of pre-tax inequality we can find a cardinal notion of status such that the introduction of a labor income tax induces both a waste reduction and a strict Pareto improvement. However, under cardinal status a labor income tax is not necessarily more desirable than under ordinal status. Indeed, if status is cardinal in the sense that the status differential between being considered rich and being considered poor is strongly dependent on the income of the rich, then a labor income tax is more likely to increase social waste than under ordinal status.