Early Childhood Investment and Income Taxation

We study the impact of the income taxation on parental investment for children and its consequence on intergenerational income correlation. We estimate a life-cycle dynastic model of households and conduct counterfactual analysis to observe the effects of various tax regimes. Comparing to a no tax environment, we find that the flat taxes reduce the correlation only by one percentage points. The reduction is, however, much significant (seven percentage points) if the taxes are progressive, the average tax rate is increasing in income. The increase in income mobility is due to the increase in the fertility rate (quantity) and the decrease in the educational outcome of children (quality). We also show that when the taxes are flat within same size households but provide child benefits, which is an important component of the US income taxation, the intergenerational income correlation is four percentage points less compared to the correlation under the flat tax regime. This reduction occurs because parents with lower education invest more time in children’s human capital comparing to a flat tax regime which increases their children’s educational outcome and increases income mobility.