Endogenous Credit Constraints, Human Capital Investment and Optimal Tax Policy

Hongyan Yang ()
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Hongyan Yang: Department of Economics, University of Konstanz, Germany

No 2010-04, Working Paper Series of the Department of Economics, University of Konstanz from Department of Economics, University of Konstanz

Abstract: This paper employs a two-period life-cycle model to derive the optimal tax policy when educational investments are subject to credit constraints. Credit constraints arise from the limited commitment of debitors to repay loans and are endogenously determined by private banks under the non-default condition that individuals can-not be better off by defaulting. We show that the optimal redistributive taxation trades the welfare gain of reducing borrowing demand and of changing the credit constraints against the efficiency costs of distorting education and labor supply. In addition, we compare the optimal taxation with that when credit constraints are taken as given. If income taxation decreases (increases) the borrowing limit, taking credit constraints as given leads to a too high (low) labor tax rate. Thus, ignoring the effects of tax policy on credit constraints overestimates (underestimates) the welfare effects of income taxation. Numerical examples show that income taxation tightens the credit constraints and the optimal tax rates are lower when credit constrains are endogenized. The intuition is that redistributive taxation reduces the incentive to invest in education and to work, thus exaggerating the moral hazard problems associated with credit constraints.

Keywords: labor taxation; human capital investment; credit constraints (search for similar items in EconPapers)
JEL-codes: H21 I2 J2 (search for similar items in EconPapers)
Pages: 29 pages
Date: 2010-09-30
New Economics Papers: this item is included in nep-acc, nep-cmp, nep-cta, nep-dge, nep-hrm and nep-lab
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