The Relative Income Hypothesis

Despite its theoretical dominance, the empirical case in favor of the permanent income hypothesis is at best a weak one. Contrary to one of its basic implications, a growing body of evidence suggests that rich households save a higher propor-tion of their permanent income than poor households. Following Duesenberry (1949), we propose an overlapping generations economy where households care about relative consumption, the di¤erence between their consumption and the consumption of their reference group. As a result, an individuals consumption is driven by the comparison of his lifetime income and the lifetime income of his reference group; a permanent income version of the Duesenberrys (1949) rela-tive income hypothesis. Across households the savings rate increases with income while aggregate savings are independent of the income distribution. Positional concerns lead agents to over-consume, over-work, and under-save, relative to the welfare maximizing levels that a planner would choose. We propose a simple tax schedule that induces the competitive economy to achieve allocative e ¢ ciency. JEL Classi\u85cation: D62, E21, H21 Key words: relative consumption; relative income hypothesis; permanent income hy-pothesis.