Income Taxes, Subsidies to Education, and Investments in Human Capital

• Date: 01 February 2014
• Author: DIMITRI PAOLINI,CONCETTA MENDOLICCHIO,TITO PIETRA
• DOI: http://doi.org/10.1111/jpet.12051
• Published date: 01 February 2014

INCOME TAXES,SUBSIDIES TO EDUCATION,AND

INVESTMENTS IN HUMAN CAPITAL

CONCETTA MENDOLICCHIO

IAB, CRENoS, Universit`

a di Sassari

DIMITRI PAOLINI

DEIR and CRENoS, Universit`

a di Sassari, CREA, Universit´

e du Luxembourg

TITO PIETRA

DSE, Universit`

a di Bologna

Abstract

We study a two-sector economy with investments in human

and physical capital and imperfect labor markets. Invest-

ments are irreversible and noncontractible, due to random

matching between firms and workers. Income is allocated

according to the Nash bargaining mechanism. At equilib-

rium, given the distribution of the agents across sectors,

there is underinvestment in both human and physical capi-

tal, due to the holdup problem generated by bargaining and

noncontractibility. Self-selection of the agents into the two

sectors typically induces too many workers to invest in high

skills. Compared to the constrained efficient allocation, at

each equilibrium, there are too many people investing too

Concetta Mendolicchio, IAB. Dimitri Paolini, DEIR and CRENoS, Universit`

a di Sassari,

and CREA, Universit´

e du Luxembourg. Tito Pietra, DSE, Universit`

a di Bologna. We thank

for helpful comments R. Boucchekine, V. Vandenberghe, M. Belot, B. Decreuse, B. Van

der Linden, L. Deidda, P. Pestieau, and participants of seminars at the University of Lux-

embourg, at the Universit`

a di Salerno, at ASSET 2009, at the 9th Journ´

ees L.-A. Gerard

Varet, at ESWC and EEA 2010. We also thank an associate editor and two referees of this

journal for helpful comments. The usual disclaimers apply. We acknowledge the finan-

cial support of MIUR-PRIN 2006 and Fondazione Banco di Sardegna. The first author

acknowledges the support of the “Programma Visiting Professor” of the Universit`

adiSas-

sari. The second author gratefully acknowledges financial support from FNR (Measure

AM2c), Luxembourg.

Received February 12, 2011; Accepted January 13, 2012.

C2013 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 16 (1), 2014, pp. 24–47.

24

Income Taxes, Subsidies to Education 25

little effort in the high-skill sector. We also study the effects

of several tax policies on total expected surplus.

1. Introduction

Causes and consequences of investments in human capital are a central topic

of research in economics. Still, the analysis of the nature of the related exter-

nalities is far from settled from both the empirical and the theoretical view-

points.1Empirically, it is not obvious that there are significant, positive dif-

ferences between social and private returns to education, at least at the level

of the subsidies prevailing in most Western countries.2From a theoretical

viewpoint, the interaction of the different, potentially relevant, distortions

at play is not fully understood. Since education is heavily subsidized in most

countries, a better comprehension of these issues has policy relevance, even

if no large, unexploited, positive externalities are present. In this paper, we

extend the microeconomic analysis of the distortions related to investments

in human capital and derive some results on the welfare effects of different

policies: fixed taxes/subsidies on the direct costs of education, and taxes on

labor income.

We consider economies with three key features: (1) workers are hetero-

geneous ex ante; (2) investments in human and physical capital are noncon-

tractible; and (3) there are two separate sectors employing different kinds

of human and physical capital, so that agents must choose both the amount

and the type of their investments.

We consider only pecuniary externalities and abstract from the possible

existence of technological ones (Lucas 1988). Our economy is basically a

two-sector generalization of the one considered in Acemoglu (1996), one of

the most interesting attempts to provide an explicit microeconomic foun-

dation for the existence of positive, pecuniary externalities related to hu-

man capital. Since his model will be a sort of benchmark for our analy-

sis, we briefly sketch its main features here. Firms and workers choose the

amount of their investments in physical and human capital. Then, they are

matched randomly, but preserving full employment. Income distribution is

determined by a bargaining process. Random matching implies that the ir-

reversible investments are noncontractible. This, together with the income

allocation based on bargaining, generates a bilateral holdup problem. In-

vestments in both human and physical capital are inefficiently low due to

the holdup mechanism, as usual in this literature. Hence, these economies

1Recent surveys of some of these issues are in Moretti (2004) and Halfdanarson,

Heuermann, and S¨

udekum (2008).

2For instance, Heckman, Layne-Farrar, and Todd (1996) and Acemoglu and Angrist

(2001) reach a negative conclusion for the United States, De la Fuente (2003)forthe

E.U. countries.