Optimal taxation with risky human capital
Economics Department Discussion Papers Series
University of Exeter
We study optimal tax policies in a life-cycle economy with risky human capital and permanent ability differences, where both ability and learning effort are private information of the agents. The optimal policies balance several goals: redistribu- tion across agents, insurance against human capital shocks, incentives to accumulate human capital, and incentives to work. We show that, in the optimum, i) if util- ity is separable in labor and learning effort, the inverse marginal labor income tax rate follows a random walk, ii) the “no distortion at the top” result does not ap- ply if discouraging labor supply increases incentives to invest in human capital, and iii) quantitatively, high-ability agents face very risky consumption in order to elicit learning effort while low-ability agents are insured. We also find large welfare gains for the U.S. from switching to an optimal tax system.
Discussion paper; also available on SSRN at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2700607