Taxing capital? The importance of how human capital is accumulated

Abstract

This paper shows that in a life-cycle framework, the optimal tax on capital crucially depends on how human capital is accumulated. We focus on three cases common to the macroeconomic literature: (i) Learning-By-Doing (LBD), (ii) Learning-Or-Doing (LOD), and (iii) exogenous accumulation. First, we show analytically in a simple two-period model that endogenizing human capital introduces novel motives for the government to tax capital when it cannot directly condition taxes on age, and moreover that these motives differ depending on whether LBD or LOD is assumed. We then quantify differences in optimal capital taxes using a rich life-cycle framework that features heterogeneity in learning ability and initial human capital. With proportional taxes, the optimal capital tax is 16pp higher with LBD than with exogenous accumulation, but 2pp lower with LOD than with exogenous accumulation. We show that heterogeneity in learning ability strengthens the novel channels introduced by human capital, resulting in a larger gap in capital taxes between LBD and LOD relative to a case with homogeneous workers. Finally, we show that although allowing the government to make labor taxes progressive reduces the gap in optimal capital taxes, a sizable gap still persists.