Catalyzers for Social Insurance : Education Subsidies vs. Real Capital Taxation

Abstract

We set up a two-period model, where individuals finance educational investment and first-period consumption by borrowing against risky second-period labor income. We show that the government should use both education subsidies and capital taxation to mitigate distortions, stemming from social insurance through labor taxation, and we derive a Ramsey-rule for the optimal combination of these instruments. Relative to capital taxation, optimal education subsidies increase in their relative effectiveness to boost labor and in individuals underinvestment into education, but they decrease in their relative net distortions. For their absolute levels, indirect complementarity effects, i.e., influencing the effectiveness of the other instrument, do matter. Generally, a decrease in capital taxes should go along with an increase in education subsidies. We also show that, even under uncertainty, the optimal capital tax rate can be zero, if education subsidies are equally effective in boosting labor supply, relative to distorting educational investment.