Working Paper: CEPR ID: DP10806
Authors: Dirk Krueger; Alexander Ludwig
Abstract: In this paper we compute the optimal tax and education policy transition in an economy where progressive taxes provide social insurance against idiosyncratic wage risk, but distort the education decision of households. Optimally chosen tertiary education subsidies mitigate these distortions. We highlight the quantitative importance of general equilibrium feedback effects from policies to relative wages of skilled and unskilled workers: subsidizing higher education increases the share of workers with a college degree thereby reducing the college wage premium which has important redistributive benefits. We also argue that a full characterization of the transition path is crucial for policy evaluation. We find that optimal education policies are always characterized by generous tuition subsidies, but the optimal degree of income tax progressivity depends crucially on whether transitional costs of policies are explicitly taken into account and how strongly the college premium responds to policy changes in general equilibrium.
Keywords: education subsidy; progressive taxation; transitional dynamics
JEL Codes: E62; H21; H24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| subsidizing higher education (I22) | reduces the college wage premium (J39) |
| optimal education policies (H52) | mitigate the distortions caused by progressive taxation on education decisions (H31) |
| as the share of college-educated workers increases due to subsidies (J24) | the wage differential between skilled and unskilled workers decreases (F66) |
| the optimal degree of income tax progressivity (H21) | is contingent upon the transitional costs of policies and the responsiveness of the college wage premium (J39) |
| without accounting for transitional dynamics (C69) | optimal policy suggests higher tax progressivity (H21) |
| when transitional dynamics are included (C69) | recommended tax structure becomes less progressive (H29) |
| optimal education subsidy rate (H52) | is 150% of college tuition costs (I23) |
| marginal tax rate (H21) | is approximately 22% (Y10) |
| optimal education subsidy rate and marginal tax rate (H21) | result in significant welfare gains (D69) |