Tinbergen (1975) wanted to reduce inequality through lowering the skill premium by increasing the supply of skilled workers relative to unskilled workers. Tinbergen’s concern with growing inequality between skilled and unskilled workers is as relevant today as it was back in the 1970s. Currently, many Western countries are confronted with sharply increasing skill premiums. The dominant explanation for this phenomenon is skill-biased technological change which causes the demand for skilled workers to increase more rapidly than the supply of skilled workers (Katz and Autor, 1999). In Tinbergen’s (1975) terminology: the race between education and technological development is currently lost by schooling.
In light of the deteriorating labor market position of low skilled workers it not surprising that subsidies to foster skill formation have a strong policy appeal. By boosting human capital formation, equality may be served because general equilibrium effects on wages reduce the skill-premium. As there is less pre-tax inequality, the need to redistribute incomes through distorting income taxes diminishes at the same time. The question of this paper is whether exploiting general equilibrium effects by means of education subsidies is indeed part of the optimal redistributive tax and education system.
This paper adds general equilibrium effects to the model of Bovenberg and Jacobs (2005). These authors extend the Mirrlees (1971) model of optimal income taxation with endogenous human capital formation, so as to analyze the simultaneous setting of optimal tax and education policies. Their main finding is that human capital formation should not be taxed or subsidized in an optimal redistributive program with linear or non-linear taxes and subsidies. Jacobs and Bovenberg (2007) show that some conditions are required to obtain this result: the earnings function should be weakly separable in ability, labor and education, and, the human capital production function should have a constant elasticity in educational investment when linear instruments are considered. A constant elasticity of the human capital production function implies that education is linear in labor earnings. Hence, a flat linear education subsidy is distributionally equivalent to a flat income tax.
The income tax, however, does not distort skill formation, whereas the education subsidy does. So the government abstains from using the education subsidies for distributional reasons under linear policy instruments. The income tax is the most efficient instrument to redistribute resources, and education policy is targeted only at off-setting the distortions of the income tax on skill formation. Under non-linear income taxation, the same intuition holds true: education subsidies are distributionally inferior to income taxes, whereas they distort the education decision and, income taxes do not. Under non-linear policies, the production function of human capital is furthermore not required to have a constant elasticity.
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Optimal Redistributive Tax and Education Policies in General Equilibrium
