Optimal Wealth Taxes with Risky Human Capital

We study the structure of optimal wedges and wealth taxes in a Mirrleesian economy with endogenous skills. Human capital is a private state variable that drives the skill process of each individual. Building on the findings of the labor literature, we assume that human capital investment is a) risky, b), done early in the life-cycle, and c) indistinguishable from consumption. These assumptions lead to the optimality of a) a human capital premium, i.e., an excess return on human capital relative to physical capital, b) a large intertemporal wedge early in the life-cycle stemming from the lack of Rogerson's (1985) "inverse Euler" characterization of the optimal consumption process, and c) an intra-temporal distortion of the effort/consumption margin even at the top of the skill distribution at all dates except of the terminal date. The main implication for the structure of linear wealth taxes is the necessity of deferred taxation of wealth. In particular, deferred taxation of wealth prevents the agents from making a joint deviation of under-investing in human capital ex ante and shirking at some future date in the life-cycle, as the marginal differed tax rate on wealth held early in the life-cycle is history-dependent. Also, the present value of aggregate marginal tax rate is zero at all dates, which means that, as in Kocherlakota (2005), the government revenue from wealth taxation is zero. Relative to economies with exogenous skills, the optimal marginal wealth tax rate is more volatile