The Effect of Endogenous Human Capital Accumulation on Optimal Taxation

Abstract

This paper considers the impact of endogenous human capital accumulation on optimal tax policy in a life cycle model. Including endogenous human capital accumulation, either through learning-by-doing or learning-or-doing, is analytically shown to create a motive for the government to use age-dependent labor income taxes. If the government cannot condition taxes on age, then it is optimal to use a tax on capital in order to mimic such taxes. Quantitatively, this work finds that introducing learning-by-doing or learning-or-doing increases the optimal tax on capital by forty or four percent, respectively. Overall, the optimal tax on capital is thirty five percent larger in the model with learning-by-doing compared to the model with learning-or-doing implying that how human capital accumulates is of significant importance when determining the optimal tax policy. JEL: E24, E62, H21.Key Words: Optimal Taxation, Capital Taxation, Human Capital.In their seminal works, Chamley (1986) and Judd (1985) determine that it is not optimal to tax capital in an infinitely-lived agent model. In such a model, taxing capital income is equivalent to an ever increasing tax on future consumption, thus implying an exponentially increasing distortion between the marginal rate of substitution and the marginal rate of transformation. In contrast, in a life cycle model agents live for a finite number of periods so the distortion imposed by a capital tax is bounded and may not necessarily be bigger than the distortions caused by other taxes. Atkeson et al. (1999), Erosa and Gervais (2002), and Garriga (2001) demonstrate in simplified life cycle models that if the government cannot condition labor income taxes on age, then it will generally tax capital in order to mimic an age-dependent tax. 1 The * E-mail: william.peterman@gmail.com. Views expressed on this site are my own and do not reflect the view of the Federal Reserve System or its staff. For extensive discussions and helpful comments, I thank Irina Telyukova, Valerie Ramey, Roger Gordon, and Scott Borger, as well as seminar participants at University of California at San Diego, Madrid Macroeconomic Workshop, the Federal Reserve Board of Governors, the Federal Reserve Bank of Philadelphia, the Eastern Economics Association Conference, the Missouri Economics Conference, the Midwestern Macroeconomics Conference, and the Conference in Computing in Economics and Finance. A previous version of this paper was distributed under the title "The Effect of Learning-by-Doing on Optimal Taxation" 1 Atkeson et al. (1999) demonstrate a related result. They show conditions under which the optimal tax on capital is zero if agedependent taxes on labor income are allowed. Gervais (2010) demonstrates that a progressive labor income tax can also mimicking age-dependent taxes on labor income.

Determining the Motives for a Positive Optimal Tax on Capital

“…When searching for the optimal tax policy, I limit my attention to flat taxes instead of searching over progressive tax policies. Conesa et al (2009) andPeterman (2010) solve for the optimal tax policies in a model similar to the benchmark model. They both find that the optimal tax policies are flat taxes in models that do not include within cohort heterogeneity.…”

“…One such study, Conesa et al (2009) uses a calibrated life cycle model and finds that the optimal tax policy consists of flat tax rates on capital and labor income of 34 percent and 14 percent, respectively. 3 Additional studies such as Gervais (2010), Garriga (2001), Peterman (2010), Smyth (2006), andİmrohoroǧlu (1998) find a non-zero tax on capital is optimal in an OLG model. Given the computational complexities of these OLG models, it is helpful to determine the economic factors driving these results.…”

Income tax progressivity, growth, income inequality and welfare

“…In a similar set-up, Conesa et al (2009) conclude that, also for the US case, the optimal capital income tax (flat) rate is 36 %, while the optimal progressive labor income tax consists of a flat tax of 23 % with a deduction of $7,200. In a closely related paper, Peterman (2014) finds that the introduction of human capital causes a 4.7 % increase in the optimal capital tax and a notably flatter optimal labor income tax. Carroll and Young (2011) find that increases in the progressivity of the income tax schedule are associated with long-run distributions with greater aggregate income, wealth, capital and labor, and lower income inequality and higher wealth inequality.…”

Optimal Taxation with Risky Human Capital

“…Our paper is also related to a recent research that quantitatively studies optimal tax reforms in environments with endogenous human capital such as Gorry and Oberfield (2012), Krueger and Ludwig (2013) and Peterman (2014). This literature is able to consider richer frameworks than ours by restricting taxes to specific functional forms.…”