An Empirical Study of the Effects of Relative Income and Income Inequality on Subjective Well-Being in the United Kingdom

Abstract

The main objective of this empirical dissertation is to understand the effects of comparison income on individual well-being. In order to do this, elements of the value function of prospect theory (Kahneman and Tverky, ), such as reference dependence, asymmetry of valuations and loss aversion are considered. Several hypotheses are tested: 1) the importance of own income; 2) the relevance of the income of the reference group (reference income); 3) the relevance of relative income (distance between own income and reference income); 4) asymmetries of comparisons (i.e., the comparison income effect on subjective well-being (SWB) differing between people above or below the reference income); 5) the importance of income inequality on SWB; and 6) asymmetries of effects of inequality on SWB depending on position in the income distribution (i.e., for people above and below the reference income group). The analysis uses a self-reported measure of life satisfaction as a proxy for SWB. The data come from the first cross section of the Annual Population Survey (2011), dedicated to subjective well-being in the United Kingdom. The main conclusions, assuming causality of income on SWB, are that comparison income is more relevant than absolute income for SWB, the effect of the reference income on SWB is negative, individual well-being increases the larger the income is in comparison to the reference income, comparisons are upward looking i.e., only negative externalities from high earners, which means asymmetries of valuation on SWB, and suggests loss aversion (Kahnemann and Tversky, 1991). Furthermore, it is observed that inequality aversion is independent of position in the income distribution. Finally, considering that SWB is increasing in popularity and also that it is becoming relatively important in economics, further theoretical and empirical research is recommended, for instance with regard to causality and unobserved heterogeinity issues.