Human capital accumulation through learning and training both in school and the workplace has become increasingly important in the last decade. A natural and important question to ask is: what is the optimal way to motivate students’ and workers’ efforts in learning and training? Surprisingly, few studies in the agency literature have attempted to answer this question. A distinctive feature of effort in human capital accumulation is that such effort affects the agent’s future productivity as well as current performance. This investment effort is the central element of dynamics in other fields of economics, but has been largely ignored in the agency literature. Thus, we ask three main questions in this paper: (i) what is the optimal incentive contract for an agent’s (human) capital investment? (ii) Does the optimal contract provide any additional insights on the internal wage structure of a firm? and (iii) Can we find any consistent evidence for the optimal contract in data?

Even when an agent’s performance depends only upon his current effort, the optimal contract in a repeated moral hazard model becomes quickly intractable as the number of periods increases (see Rogerson, 1985). Consequently, when an agent’s performance depends on his previous efforts as well as his current effort, analyzing an optimal contract can be potentially very complicated. However, we show that the optimal contract can be remarkably simple. Assuming no discounting, the optimal wage is constant except for the last period, and in this last period, the optimal wage contract relies only upon the last period performance. Therefore, the principal need only monitor the agent’s performance in this last period!