Optimal Income Taxation with Endogenous Human Capital

This paper augments the theory of optimal linear income taxation by taking into account human capital accumulation as a dimension of labor supply. The distribution of earnings potentials endogenous, because agents differ in ability to learn. Taxation affects utilization rates of human capital as labor supply is affected. Non tax-deductible costs distort the learning decision as well. We show theoretically that the trade-off between efficiency costs of taxation and equity aspects of redistribution is worsened. Quantitative analysis indicates that distortionary costs of taxation increase substantially when learning is endogenous