Catalysts for social insurance: education subsidies versus physical capital taxation

To analyze the optimal social insurance package, we set up a two-period life-cycle model with risky human capital investment in which the government has access to labor taxation, education subsidies, and capital taxation. Social insurance is provided by redistributive labor taxation. We point out that both education subsidies and capital taxation are used as catalysts to facilitate social insurance by mitigating distortions from labor taxation. Moreover, we derive a Ramsey rule for the optimal combination of these two instruments. Relative to capital taxation, optimal education subsidies increase with their relative effectiveness to boost labor supply and with households’ underinvestment in education, but they decrease with their relative net distortions. For the optimal absolute levels, indirect complementarity effects (i.e., influencing the effectiveness of the other instrument) do matter. Numerical simulations confirm that the catalysts are strategic substitutes and indicate that capital taxation is more important.