Consumption externalities, habit formation and optimal dynamic non‐linear income taxation under asymmetric information

Abstract This article proposes a 2‐period model featuring jointly habit formation, consumption externalities and asymmetric information to investigate their impacts on optimal labour and saving taxes. Regarding the effect of habit formation only, our model suggests that both labour taxation in the first period and a capital subsidy between the first and second period are used to deter consumption in the first period. However, when the impact of consumption externalities alone is considered, consumption externalities advocate for higher labour taxation for all agents. Finally, our quantitative results show that with the rising degree of consumption externalities, the discrepancy between marginal capital tax rates under full information and their values under asymmetric information falls, so does the change in the gap between the marginal labour income tax rates of the skilled and the unskilled. Conversely, as the degree of habit formation increases, the change in marginal capital tax rates under full information and under asymmetric information expands, so does the change in the gap between the marginal labour income tax rates of the skilled and the unskilled.