Risky Human Capital Formation Requires Siamese Twins

Based on the OLG-model and the two-bracket labor tax system by Nielsen and Sørensen (1997), we model an economy, where human capital formation is liable to idiosyncratic risk. We show that, compared to a standard Eaton and Rosen (1980) world, extending the instruments available for the government to progressive taxation and education subsidies generalizes the Siamese Twins -result by Bovenberg and Jacobs (2005) to the case of risky labor income. Hereby, progressivity is a superior instrument for insurance, and education subsidies are again used in order to alleviate efficiency losses