• We would like to thank Kazuo Mino, two anonymous referees, Hung-Ju Chen, Yu-Chin Chen, Minchung Hsu, Richard Suen, Shu-Chun Susan Yang, and seminar participants in the 2010 Chinese Economic Association in North America at the Allied Social Science Association Meetings and the 10th Society for the Advancement of Economic Theory Conference for helpful comments and suggestions. Part of this research was conducted while Guo was a visiting research fellow at the Institute of Economics, Academia Sinica, whose hospitality is greatly appreciated. All remaining errors are our own.


This paper examines the first-best fiscal policy in a stochastic, infinite-horizon representative agent model that exhibits consumption-enhanced as well as wealth-enhanced social status in the household utility. We show that the first-best labour tax rate is a positive constant that is used to correct negative consumption externalities. The first-best tax rate on capital income is also positive in order to overturn agents' status-seeking capital over-accumulation. Moreover, we find that in sharp contrast to a conventional automatic stabilizer, the first-best capital tax rate moves in the opposite direction with shocks to firms' production technology, thus exacerbating the business cycle.