Optimal taxation in the life cycle with human capital investment

This paper studies optimal taxes in a lifecycle model with unverifiable human capital investment inseparable from regular consumption. The planner faces asymmetric information regarding agents’ exogenous abilities and endogenous human capital. Agents deviate in two ways: misreporting ability and mis-investing in human capital. We characterize the distortions in a model with i.i.d. shocks and full human capital depreciation. Distortions are characterized by capital wedges that are positive over the life cycle, labor wedges that are negative early and positive later in the life cycle, and net human capital wedges that are positive in the life cycle. These wedges serve as mechanisms to eliminate the distortion to consumption due to inseparability from education expenditure. Calibrate to U.S. data, we show numerically that these results apply in a richer model with persistent shocks and non-full human capital depreciation. Simulation suggests that average capital wedges are positive in all working periods, with progressive capital wedges in contemporary skills, average labor wedges are negative in early and positive in later periods, with hump-shape in skills and nonzero at the top and the bottom of the skill distribution, and net human capital wedges are positive and regressive in skills, indicating that human capital subsidies are in favor of the high skilled.