Consumption externalities, market imperfections and optimal taxation

In a dynamic model with a keeping-up-with-the Joneses preference and market imperfections, we attempt to investigate under what circumstances and for what reason the optimal tax should be state-varying. We extend the Ljungqvist and Uhlig (2000) proposition to include preferences that exhibit non-homotheticity. We show that a keeping-up-with-the-Joneses preference (a non-intertemporally-dependent preference) can lead the social planner to commit to a state-contingent tax on labor income. Moreover, the optimal labor income tax can be either procyclical or countercyclical with respect to economic fluctuations, this crucially depending on whether the level of contemporaneous consumption increases or decreases the wedge between the intertemporal substitution elasticity of households and of the social planner.