Optimal Taxation of Human Capital and the Earnings Function

Abstract

This paper explores how the specification of the earnings function impacts the optimal tax treatment of human capital. If education is complementary to labor effort, education should be subsidized to offset tax distortions on labor supply. However, if most of the education is enjoyed by high ability households, education should be taxed in order to redistribute resources to the poor. The paper identifies the exact conditions under which these two effects cancel and education should be neither taxed nor subsidized. In particular, with non-linear tax instruments, education should be weakly separable from labor and ability in the earnings function. With linear taxes, education should also feature a constant elasticity in a weakly separable earnings function.JEL Code: H2, H5, I2, J2.

Optimal redistributive tax and education policies in general equilibrium

“…Therefore, educational investments are efficient in the presence of an optimal income tax. The intuition is similar as in Bovenberg and Jacobs (2005) and Jacobs and Bovenberg (2011). Education subsidies do not reduce the labor supply distortion more compared to an equally costly reduction in income taxes.…”

“…With the earnings functions used by Bovenberg and Jacobs (2005), both effects cancel out, and the sole role of education subsidies is to offset the distortions of the income tax on skill formation. Indeed, the Diamond and Mirrlees (1971) production efficiency theorem dictates that all investments in human capital (an intermediate input) are efficient under these conditions (Jacobs and Bovenberg 2011). This paper closely follows the analysis of Bovenberg and Jacobs (2005).…”

“…Note that the distributional characteristic of education is equal to the distributional characteristic of income because gross earnings are linear in education due to the constant elasticity of the production function for human capital. This assumption ensures that (negative) education subsidies are distributionally equivalent to income taxes, see also Jacobs and Bovenberg (2011). In the remainder, the superscripts are dropped, and ξ ≡ ξ z = ξ e .…”

“…6 To ensure that optimal education subsidies are zero in the absence of general equilibrium effects, the earnings function is weakly separable in ability, education, and labor. The elasticity of the production function is also assumed to be constant under linear policies, and is denoted by β ≡ φ (e n )e n φ(e n ) (Jacobs and Bovenberg 2011). In general equilibrium, the high-ability type is assumed to earn a higher gross wage than the low-ability type so as to obtain an economically meaningful redistribution problem, i.e., w 1 h 1 l 1 > w 2 h 2 l 2 .…”

“…In particular, the earnings function is assumed to be weakly separable between ability, labor, and education, both with linear and nonlinear policies. Additionally, the production function for human capital is assumed to have a constant elasticity if linear policies are considered, see also Jacobs and Bovenberg (2011). Individuals also have an iso-elastic utility function, so that labor supply elasticities are constant, and income effects are absent.…”