Optimal Taxation of Human Capital and the Earnings Function

This paper explores how the specification of the earnings function impacts the optimal tax treatment of human capital. If education is complementary to labor effort, education should be subsidized to offset tax distortions on labor supply. However, if most of the education is enjoyed by high ability households, education should be taxed in order to redistribute resources to the poor. The paper identifies the exact conditions under which these two effects cancel and education should be neither taxed nor subsidized. In particular, with non-linear tax instruments, education should be weakly separable from labor and ability in the earnings function. With linear taxes, education should also feature a constant elasticity in a weakly separable earnings function.