Should Day Care be Subsidized?

Abstract

In an economy with distortionary taxes on labour, can subsidies on day care, financed by increased taxes, raise welfare by encouraging women with small children to work? We show, within a stylized life-cycle framework, that the Ramsey optimal policy consists in equalizing consumption/leisure wedges over the life cycle. A simple way to implement this is to make day care expenses tax deductible. Modifying and calibrating our model to fit some key facts about labour supply in Germany, we find that the reform that maximizes a distribution-neutral social welfare function involves subsidizing day care at a rate of 50% and leads to a near doubling of labour supply for mothers with small children. The overall welfare gain from this reform corresponds to a 0.4 percent increase in consumption.