Tax Reform and Human Capital Accumulation: Evidence from an Empirical General Equilibrium Model of Skill Formation

The progressivity of the tax system has a potentially large disincentive effect on human capital accumulation. It is thus surprising that Heckman, Lochner, and Taber (1998b, 1999a,b) represent the only previous empirical work on this important topic. I build on their work a) by accounting for the tax system when estimating the model, b) by performing welfare analysis, c) by examining the transition from one steady state to another, and d) by adding a number of robustness checks. I first estimate a dynamic general equilibrium model of schooling and on-the-job training on micro data. The estimates are then used to measure the extent to which the progressivity of the tax system distorts human capital. I find a small long run effect of progressivity on schooling. I find larger short run effects, but that they are short lived. The impact of the reform on human capital acquired on the job depends on how it is measured. Under one measure the effect is large, but the consequence of this on earnings seems to be small. Perhaps surprisingly, the welfare effects are typically favorable for progressive wage taxes (with flat capital taxation) versus a flat income tax in the long run. The welfare effects are different when I examine a progressive income tax as virtually all workers prefer the flat income tax to it. I also build on Heckman, Lochner, and Taber's (1998b,1999a,b) evidence on the extent to which taxation of physical capital favors human capital investment. These simulations also yield small long run effects on schooling and on human capital stocks.