, Volume 17, Issue 5, pp 451-478,
Open Access This content is freely available online to anyone, anywhere at any time.
Date: 03 Jul 2009

Human capital and optimal positive taxation of capital income

Abstract

This paper analyzes optimal linear and non-linear taxes on capital and labor incomes in a life-cycle model of human capital investment, financial savings, and labor supply with heterogenous individuals. A dual income tax with a positive marginal tax rate on not only labor income but also capital income is optimal. The positive tax on capital income serves to alleviate the distortions of the labor tax on human capital accumulation. The optimal marginal tax rate on capital income is lower than that on labor income if savings are elastic compared to investment in human capital, substitution between verifiable and non-verifiable inputs in human capital formation is difficult, and most investments in human capital are verifiable so that education subsidies can directly reduce the tax wedge on learning. Numerical calculations suggest that the optimal marginal tax rate on capital income is substantial.

The authors thank Richard Blundell, Martin Gervais, Søren Bo Nielsen, Rick van der Ploeg, and seminar participants at the University of Amsterdam, the London School of Economics, the Institute for Fiscal Studies, and members of the CESifo area conference on Public Economics, May 7–9, 2004, München for useful comments and suggestions. Bas Jacobs gratefully acknowledges financial support from the NWO Priority Program ‘Scholar’ and for financial support from the Dutch Organization for Sciences (NWO Vidi Grant No. 452-07-013, ‘Skill Formation in Distorted Labor Markets’). This paper previously circulated under the title “Optimal Capital Income Taxation with Endogenous Human Capital Formation”.