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Second-Best Income Taxation with Endogenous Human Capital and Borrowing Constraints

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  • Bas Jacobs
  • Hongyan Yang

Abstract

We formulate a two-period life-cycle model of saving, labor supply, and human capital investments when individuals differ in ability and initial wealth. Borrowing constraints prevent individuals to optimally smooth consumption over the life-cycle and to optimally invest in human capital. We show that the optimal linear income tax is positive - even in the absence of any redistributional concerns. A progressive income tax is efficient because it relaxes borrowing constraints by redistributing resources from the unconstrained to the borrowing constrained stages of the life-cycle. Hence, consumption is smoothed better and investments in human capital increase. The progressive income tax is a second-best instrument to correct the non-tax distortion in the capital market. The equity-efficiency trade-off is therefore less severe when progressive income taxes mitigate capital market imperfections. Simulations demonstrate that optimal income taxes are substantially higher when they alleviate credit constraints.

Suggested Citation

  • Bas Jacobs & Hongyan Yang, 2013. "Second-Best Income Taxation with Endogenous Human Capital and Borrowing Constraints," CESifo Working Paper Series 4155, CESifo.
  • Handle: RePEc:ces:ceswps:_4155
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    2. Bhattacharya, Joydeep & Qiao, Xue & Wang, Min, 2016. "Endogenous Borrowing Constraints And Wealth Inequality," Macroeconomic Dynamics, Cambridge University Press, vol. 20(6), pages 1413-1431, September.

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    More about this item

    Keywords

    labor taxation; human capital investment; credit constraints;
    All these keywords.

    JEL classification:

    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • I20 - Health, Education, and Welfare - - Education - - - General
    • J20 - Labor and Demographic Economics - - Demand and Supply of Labor - - - General

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