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

In this paper we characterize quantitatively the optimal mix of progressive income taxes and education subsidies in a model with endogenous 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 heterogeneous households. In addition to the standard distortions of labor supply progressive taxes also impede the incentives to acquire higher education, generating 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.