Estimating wealth-sensitive relative income effects in Britain

Duesenberry’s (1949) relative income hypothesis says that the utility of an individual depends not only on his absolute income level, but also on his relative income position in society. An individual gains utility if his income exceeds the income of most members in his comparison group and loses utility if his income falls below the income of most members in the group. Many empirical studies already show that these relative income effects have a significant role in determining well-being (e.g., Easterlin, 1995). However, most of them consider a symmetric case where the relative effects are homogenous among the population, or a simple version of asymmetric case in which the population is categorized into two groups, conditioning on whether one’s income level is higher or lower than one’s reference group. The distribution nature of relative income effects may be much more complicated, however, as two similarly-situated individuals may feel differently about their relative positions. The current analysis estimates the British Household Panel Survey (BHPS) and depicts a broader asymmetry – wealth-sensitive relative income effects. To explore the empirical possibility of wealth-sensitive relative income effects, I regress a utility proxy on own income, the average income of the reference group, and an interaction of the two. A significant interaction suggests that one’s relative income effect depends on one’s current income level. Investigating the properties of relative income effects is important since it can point out directions and suggestions for various government policies. For example, the result of the current study may help us understand the optimal income tax model more effectively. Also, scholars already apply wealth-sensitive relative income effects into their analysis. The current study can provide empirical support.