Human Capital, Polarization, and Pareto-Improving Activating Welfare

Human capital not only generates market income but is a direct source of utility as well. The interaction between the non-economic motive for effort and the standard economic motive can generate multiple stationary solutions for individual household optimization. Depending on the initial distribution of skills, this multiplicity divides each group of otherwise identical households into two perpetually separated groups: one rich and educated, one poor and uneducated. If the rich have an interest in the education of the poor, polarized equilibria are typically Pareto-inefficient. While unconditional transfers only reduce the incentive of the uneducated to accumulate skills, there exist activating tax-transfer systems that Pareto-dominate any non-redistributing system. Transfers are transitory and there is a negative marginal income tax on household income below a certain threshold.