Optimal Progressive Labor Income Taxation and Education Subsidies When Education Decisions and Intergenerational Transfers are Endogenous

Abstract

We quantitatively characterize 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. In addition to the distortions of labor supply, progressive taxes weaken the incentives to acquire education. 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 US status quo.