Human Capital, Polarisation and Pareto-improving Activating Welfare

Human capital not only earns income but also is a source of direct felicity. The interaction between these two motives for effort can generate multiple stationary solutions for individual household optimisation. This multiplicity freezes any sufficiently unequal initial skill distribution and persistently segregates households into two separate groups: one rich and educated, one poor and uneducated. If public goods are to be financed, polarisation is typically Pareto-inefficient. While unconditional transfers only reduce the incentive to accumulate skills, activating tax-transfer systems that Pareto-dominate any non-redistributing system exist. Transfers are transitory and a negative marginal income tax is imposed on poor households’ income.