The Dynamics of Optimal Taxation when Human Capital is Endogenous. Working Paper

This paper characterizes the dynamics of Pareto efficient income taxes in a dy-namic economy with unobservable human capital accumulation. I extend the tools and insights developed by Mirrlees (1971) into a dynamic framework. I follow Dia-mond (1998) by assuming that there are no income effects on labor supply. I show that if the government have access to perfect credit markets then i) the problem of finding the efficient allocation can be decomposed into two relatively simple stages and ii) if the agents have access to perfect capital markets as well then the efficient allocations may be implemented in a competitive equilibrium by using history independent income taxes. I compute the sequence of optimal income taxes and show that the marginal in-come taxes tend to decrease over time and that the decrease is approximately uniform for all skill levels. I also find that, in terms of aggregate output, the dynamic gains from the adjustment of human capital are about 17 times larger than the static gains from the initial labor supply adjustment