Optimal Capital and Progressive Labor Income Taxation with Endogenous Schooling Decisions and Intergenerational Transfers

Alexander Ludwig and Dirk Krueger

No 334, 2015 Meeting Papers from Society for Economic Dynamics

Abstract: In this paper we characterize quantitatively the optimal mix of progressive labor income and capital income taxes as well as and education subsidies in a model with endogenous human capital formation, borrowing constraints, income risk. and incomplete financial markets. Progressive labor income taxes provide social insurance against idiosyncratic income risk and redistributes after tax income among ex-ante heterogeneous households. In addition to the standard distortions of labor supply progressive taxes also impede the incentives to acquire higher education, generating a non-trivial trade-off for the benevolent utilitarian government. The latter distortion can potentially be mitigated by an education subsidy. We find that the welfare-maximizing fiscal policy is indeed characterized by a substantially progressive labor income tax code and a positive subsidy for college education. The optimal degree of the education subsidy is larger than in the current U.S. status quo.

Date: 2015
New Economics Papers: this item is included in nep-dge, nep-edu and nep-pbe
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