Optimal Taxation in a Life-Cycle Economy with Endogenous Human Capital Formation

We study efficient allocations and optimal policies in a life-cycle economy with risky human capital accumulation. The agents are ex-ante heterogeneous in their initial human capital and in their ability level. Ex-post, they also differ in their realization of shocks to human capital. The model incorporates two frictions. First, it assumes that ability and labor supply are both private information of the agents. Second, it adds a moral hazard component by assuming that schooling and realized rates of return to human capital are both private information. The model is sufficiently rich enough to be useful for policy analysis, and we show that it is also tractable enough to carry out the normative analysis. We assume that abilities are permanent and show that, under certain conditions, the inverse of the intratemporal wedge follows a random walk. This result is, to our knowledge, novel and implies that average intratemporal wedge increases over time. We provide preliminary quantitative simulations for a two period economy and find that high ability agent face the largest expected increase in the intratemporal wedge. At the top of the ability distribution the expected increase in the intratemporal wedge is about 10%.