Optimal Income Taxation with Endogenous Human Capital

This paper augments the theory of optimal linear income taxation by taking into account human capital accumulation as a dimension of labor supply. The distribution of earning potentials is endogenous because agents differ in the ability to learn. Taxation affects utilization rates of human capital through labor supply responses. The costs of education that are not deductible from the income tax distort the learning decision as well. We show theoretically that the trade- off between efficiency and equity is worsened. Quantitative analysis shows that the distortionary costs of taxation increase substantially when human capital formation is endogenous. "It has long been understood that the concept "labor supply" is more general than "hours of work." If one individual is healthier, better educated and more highly motivated than another, then presumably a given number of hours of work will lead to greater effective la- bor supply for the former than for the latter. Thus, studies on the effect of taxes on other dimensions of labor supply are needed in order to assess the full impact of taxes on work incentives." Rosen (1980, p. 171).