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Optimal Progressive Taxation and Education Subsidies in a Model of Endogenous Human Capital Formation

  • Dirk Krueger

    ()

    (Department of Economics, University of Pennsylvania)

  • Alexander Ludwig

    ()

    (University of Cologne, Faculty of Management, Economics and Social Sciences)

In this paper we characterize quantitatively the optimal mix of progressive income taxes and education subsidies in a model with endogeneous 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 heterogenous households. In addition to the standard distortions of labor supply progressive taxes also impede the incentives to acquire higher education, generation 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. Both the degree of tax progressivity and the education subsidy are larger than in the current U.S. status quo.

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Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 13-035.

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Length: 38 pages
Date of creation: 27 Mar 2013
Date of revision:
Handle: RePEc:pen:papers:13-035
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