Environmental Externalities and Consumer's Frames of Reference

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.