We study Pareto optimal tax and education policies when human capital upon labor market entry is endogenous and individuals face wage uncertainty. Though optimal labor distortions are history-dependent, i.e. depend on income and education, simple policy instruments can yield the desired distortions: a single nonlinear labor income tax schedule combined with income-contingent loans. To take the model to the (US) data, we simplify the model to a binary education decision (graduating from college or not). We find that for low and intermediate incomes the labor supply decision of college graduates should be distorted more heavily than for individuals without a college degree. As a consequence, the optimal student loan repayment schedule increases in income for this range. This result holds along the Pareto frontier. We compare the second best to a situation where loan repayment is restricted to be independent from income and find significant welfare gains.
JEL-classification: H21, H23, I21
We study the incidence of nonlinear labor income taxes in an economy with a continuum of endogenous wages. We derive in closed form the effects of reforming nonlinearly an arbitrary tax system, by showing that this problem can be formalized as an integral equation. Our tax incidence formulas are valid both when the underlying assignment of skills to tasks is fixed or endogenous. We show qualitatively and quantitatively that contrary to conventional wisdom, if the tax system is initially suboptimal and progressive, the general‐equilibrium “trickle‐down” forces may raise the benefits of increasing the marginal tax rates on high incomes. We finally derive a parsimonious characterization of optimal taxes.
We derive a simple sufficient-statistics test for whether a nonlinear tax-transfer system is second-best Pareto efficient. If it is not, it is beyond the top of the Laffer curve and there exists a tax cut that is self-financing. The test depends on the income distribution, extensive and intensive labor supply elasticities, and income effect parameters.A tax-transfer system is likely to be inefficient if marginal tax rates are quickly falling in income. We apply this test to the German tax-transfer system and find the structure of effective marginal tax rates likely to be inefficient in the region where transfers are phased-out.
We study the optimal design of student financial aid as a function of parental income. We derive optimal financial aid formulas in a general model. For a simple model version, we derive mild conditions on primitives under which poorer students receive more aid even without distributional concerns. We quantitatively extend this result to an empirical model of selection into college for the United States that comprises multidimensional heterogeneity, endogenous parental transfers, dropout, labor supply in college, and uncertain returns. Optimal financial aid is strongly declining in parental income even without distributional concerns. Equity and efficiency go hand in hand.
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