Optimal Taxation and Human Capital Policies Over the Lifecycle

Abstract

This paper derives optimal income tax and human capital policies in a dynamic life cycle model of labor supply and risky human capital formation. The wage is a function of both stochastic, persistent, and exogenous "ability" and endogenous human capital. Human capital is acquired throughout life through monetary expenses and training time. The government faces asymmetric information regarding the initial ability of agents and the lifetime evolution of ability, as well as the labor supply. When human capital is observable, the optimal subsidy on human capital expenses is determined by three considerations: counterbalancing distortions to human capital investment from the taxation of wage and capital income, encouraging labor supply, and providing insurance against adverse draws from the productivity distribution. When the wage elasticity with respect to ability is increasing in human capital, the optimal subsidy involves less than full deductibility of human capital expenses on the tax base, and falls with age. The optimal tax treatment of training time also depends on its interactions with contemporaneous and future labor supply. I consider two ways to implement the optimum: income contingent loans, and a tax scheme that allows for a deferred deductibility of human capital expenses. I also study the case in which human capital is unobservable, and derive how income taxes need to be adjusted to indirectly incentivize human capital acquisition. Numerical results are presented that suggest that full deductibility of expenses might be close to optimal, and that simple linear age-dependent policies can achieve most of the welfare gain from the second best.