Optimal Taxation and Human Capital Policies over the Life Cycle

This paper derives optimal income tax and human capital policies in a life cycle model with risky human capital. The government faces asymmetric information regarding agents’ ability, its evolution, and labor supply. When the wage elasticity with respect to ability is increasing in human capital, the optimal subsidy involves less than full deductibility of human capital expenses on the tax base, and falls with age. Income contingent loans or a deferred deductibility scheme can implement the optimum. Numerical results suggest that full deductibility of expenses is close to optimal and that simple linear age-dependent policies perform very well.