Redistribution Meets High Education Investment: Designing Taxes and Subsidies for Social Welfare

Abstract

While some papers address optimal taxation in the context of educational investment, the literature falls short in characterizing the optimal joint design of government higher education subsidies and income tax rates that simultaneously promotes redistribution and incentives for human capital accumulation. The model is solved analytically under general conditions and calibrated to assess its quantitative implications for efficiency, inequality, and welfare. Simulations show that incorporating education investment substantially alters the optimal level of income tax progressivity, with the effect depending on the responsiveness of human capital accumulation to after-tax returns. For an inequality-averse social planner, rising marginal tax rates generally emerge as optimal; yet, generous education subsidies—similar to those in several OECD countries—can justify decreasing marginal tax rates for high-income earners.