Risky Human Capital and Deferred Capital Income Taxation

Abstract

We study the structure of optimal wedges and capital taxes in a Mirrlees economy with endogenous skills. Human capital is a private state variable that drives the skill process of each individual. Building on the findings of the labor literature, we assume that human capital investment is a) risky, b) made early in the life-cycle, and c) hard to distinguish from consumption. These assumptions lead to the optimality of a) a human capital premium, i.e., an excess return on human capital relative to physical capital, b) a large intertemporal wedge early in the life-cycle stemming from the lack of Rogerson's [Econometrica, 1985] "inverse Euler" characterization of the optimal consumption process, and c) an intra-temporal distortion of the effort/consumption margin even at the top of the skill distribution at all dates except the terminal date. The main implication for the structure of linear capital taxes is the necessity of deferred taxation of physical capital. In particular, deferred taxation of capital prevents the agents from making a joint deviation of under-investing in human capital ex ante and shirking from labor effort at some future date in the life-cycle, as the marginal deferred tax rate on physical capital held early in the life-cycle is history-dependent. The average marginal tax rate on physical capital held in every period is zero in present value. Thus, as in Kocherlakota [Econometrica, 2005], the government revenue from capital taxation is zero. However, since a portion of the capital tax must be deferred, expected capital tax payments cannot be zero in every period. Necessarily, agents face negative expected capital tax payments due early in the life-cycle and positive expected capital tax payments late in the life-cycle. Also, relative to economies with exogenous skills, the optimal marginal wealth tax rate is more volatile.