Does the Tax System Encourage Too Much Education?

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The Nordic countries have dual income taxation, with a proportional tax on capital income and a progressive tax on labour income. Nielsen and Sorensen (1997) argue that this asym- metric treatment of the two types of income can be defended on pure e¢ciency grounds. The progressivity of the labour income tax serves to reduce the private return to human capital investment, thereby osetting the tendency of a proportional comprehensive income tax to discriminate in favour of such investments. They use a simple overlapping generations model in a small open economy. The consumer faces a trade-obetween investments in …nancial and human capital, and education serves only as a means to shift consumption between periods. The present paper expands this model by including the intrinsic value of education as a mo- tivation behind getting education. I …nd that the argument in favour of dual income taxation is strengthened. A comprehensive proportional income tax works as a tax subsidy on human capital investments, and it reduces the price of education as a consumption good. This may explain the puzzle why so many choose to get higher education in the Nordic countries, where the wage return to education is modest. By introducing a progressive labour income tax, the total return to education is reduced. Hence the e¢ciency distortion in the capital market may be partly neutralised.