Finance and Economics Discussion Series

The Effect of Endogenous Human Capital Accumulation on Optimal Taxation

William B. Peterman
2012-03

Abstract: This paper considers the impact of endogenous human capital accumulation on optimal tax policy in a life cycle model. Including endogenous human capital accumulation, either through learning-by-doing or learning-or-doing, is analytically shown to create a motive for the government to use age-dependent labor income taxes. If the government cannot condition taxes on age, then it is optimal to use a tax on capital in order to mimic such taxes. Quantitatively, introducing learning-by-doing or learning-or-doing increases the optimal tax on capital by forty or four percent, respectively. Overall, the optimal tax on capital is thirty five percent higher in the model with learning-by-doing compared to the model with learning-or-doing implying that how human capital accumulates is of significant importance when determining the optimal tax policy.

Keywords: Optimal taxation, capital taxation, human capital