The effect of endogenous human capital accumulation on optimal taxation

Abstract

This paper considers the impact of learning-by-doing on optimal tax policy in a general equilibrium heterogeneous agent life-cycle model. Analytically, it identifies two main channels by which learning-by-doing alters the optimal tax policy. First, learning-by-doing creates a motive for the government to use age-dependent labor income taxes. If the government cannot condition taxes on age, then a capital tax or progressive/regressive labor income tax can be used in order to mimic age-dependent taxes. Second, a progressive/regressive labor income tax is potentially more distortionary in a model with learning-by-doing since the distortion is propagated through the additional intertemporal link between current labor and future human capital. Quantitatively, I find that both of these channels are important for the optimal tax policy. Adding learning-by-doing leads to a notably flatter optimal labor income tax due to the second channel. Moreover, including learning-by-doing causes an increase in the optimal capital tax due to the first channel. I find that when solving for the optimal tax policy in the learning-by-doing model, the welfare consequences of not accounting for endogenous human capital accumulation are equivalent to around one percent of expected lifetime consumption, a majority of which are due to adopting too progressive of a tax policy.