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Taxation, Human Capital, and Uncertainty

Taxation, Human Capital, and Uncertainty Taxation Jonathan Eaton and Harvey S. Rosen Introduction purpose of this paper, then, is to explore the We then explored the consequences of wage The growth of tax rates on earned income has problem of efficient taxation in the context of taxation in models which allowed for endo­ the uncertainty model. focused attention upon the impact of such genous first-period consumption and endo­ taxes on work effort. The effect of taxes on genous leisure, respectively. It was shown how In Part II, we begin by studying a very hours of work has been the subject of both the behavioural parameters in these more simple uncertainty model of human capital careful theoretical and econometric study. The complicated models interact with risk aversion accumulation, and contrast the tax implications basic lesson of the theoretical literature is that in order to determine how human capital with those which fall out of the corresponding the impact of taxation on hours of work is accumulation is influenced by the wage tax. certainty case. We then examine a number of logically indeterminate because of the familiar Finally, attention was focused upon the extensions of the basic model, and ascertain conflict between income and substitution problem of efficiently taxing an individual how they influence the tax sensitivity of human effects. Therefore, an enormous amount of whose human capital yields a random return. capital accumulation. It is shown that under econometric research has been done on this An interesting result emerged. Pure lump-sum reasonable assumptions, the impact of taxation subject. Although there is a disconcertingly taxation does not necessarily minimise excess upon human accumulation is very different high variance in estimates of labour supply burden. Given risk aversion, partial reliance from that which emerges from the certainty elasticities, it would probably be fair to say on a wage tax improves allocative efficiency model. that the consensus is that the response in because it reduces the riskiness of investment hours of work to changes in the net wage is Part HI discusses the problem of optimal in human capital. very small for prime age male earners. This wage taxation when the returns to human Our models are very simple, and there are a finding has been interpreted by some as evidence capital are uncertain. We show that under number of ways in which they could be that taxes have little influence on work effort. uncertainty the efficient wage tax may exceed extended. It would be interesting to analyse zero even when lump-sum taxation provides Without doubt, theoretical and econometric cases in which returns to non-human capital an alternative source of revenue. This finding work to refine estimates of the hours response are also stochastic. Study of models in which contrasts, of course, with the well-known to changes in the tax structure will continue in the random component affects the return to result from the optimal tax literature that, the future. However, it must be noted that human capital non-multiplicatively would also under certainty, lump-sum taxation provides "work effort" and "hours of work" are not be useful. Our guess, however, is that compara­ the most efficient means of raising revenue. synonymous. Even if taxes have little impact tive statistics results on the impact of taxes The difference arises because the market fails upon quantity of hours worked, it is possible from more complicated models will not yield to insure against the risk associated with that they have an important effect on the quality many new insights. If this paper is right in its human capital. The government via the wage of number of hours worked. Examination of assertion that the unambiguous results of the tax acts as insurer and thus increases welfare. the impact of taxation upon human capital certainty models do not generalise to the un­ We follow our discussion of the positive and accumulation may provide insight into the certainty case, then empirical work is probably normative aspects of taxing the returns to effect of taxes on work effort. the most fruitful way to carry on research of human capital with some summary remarks this important question. Not very much work has been done on inte­ and suggestions for future research in Part IV. The results of Part III suggest, furthermore, grating taxation into the analysis of human the value of additional theoretical analysis of capital. Boskin studies a model of individual lifetime earnings maximisation, and shows that the design of optimal tax systems. The familiar a proportional wage tax has no effect on human result that, under certainty, commodity or Summary and Conclusions income taxation is necessarily second best does capital accumulation. Heckman and Driffill Although optimal human capital accumulation not generalise to situations characterised by the note that income (as opposed to wage) taxes has been studied intensively, little attention has presence of uncertainty which is neither will change the optimal amount of human been devoted to the impact of taxes on the diversifiable nor insurable. The uninsurability of capital accumulation because they change net human capital decision. This paper has most investments in human capital suggests discount rates. These results are all obtained studied the effect of wage and income taxes on from models in which the returns to human that departures from lump-sum taxation may human capital using a model in which the be optimal more frequently than previously capital investment are known with certainty. returns to human capital investment are un­ realised. However, as Levhari and Weiss emphasize, un­ certain. We began by studying a simple two- certainty is of paramount importance in Our conclusions also have implications for period model in which leisure and first-period human capital investment decisions. Although optimal redistributive income taxation as consumption were exogenously determined. It the taxation of non-human capital in an un­ developed for the certainty case by Mirrlees, was shown that the well-known neutrality of certainty context has been studied extensively, Fair and Feldstein (1973), for example. It may wage taxation in such a model is broken when it will be explained below that results from this be the case, for instance, that introducing the returns to human capital are uncertain. literature do not carry over to the human uncertainty of the type hypothesized in our The tax decreases the risk associated with capital case. One of the main goals of this model will, ceteris paribus raise the optimal human capital investment tending to increase paper is to analyse theoretically the effect of marginal tax rate of more risk-averse income its desirability. At the same time wage taxation taxation on human capital accumulation in a groups. These issues are worth further inquiry. lowers wealth which reduces the demand for model which explicitly allows for uncertainty. human capital ceteris paribus when the degree The authors are on the staff of Princeton of absolute risk aversion is decreasing. The University, and their full paper is available as A closely related issue is that of the optimal Working Paper 117 from the Industrial overall effect depends upon the relative taxation of wage income. Previous studies of Relations Section, Princeton University, PO strengths of these two tendencies. Similarly, efficient wage taxation have treated returns to under uncertainty it is no longer the case that Box 248, Princeton, New Jersey 08540, USA. human capital as certain. However, to the an income tax unambiguously expands human extent that introducing uncertainty changes The synopsis is taken from a longer paper capital accumulation. Quite possibly, income behavioural responses to taxes, it may change to which the American Economic Review holds taxation will discourage human capital. optimal tax rates as well. A second major final editorial rights. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Management Research News Emerald Publishing

Taxation, Human Capital, and Uncertainty

Management Research News , Volume 2 (4): 1 – Apr 1, 1979

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Emerald Publishing
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Copyright © Emerald Group Publishing Limited
ISSN
0140-9174
DOI
10.1108/eb027739
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Abstract

Taxation Jonathan Eaton and Harvey S. Rosen Introduction purpose of this paper, then, is to explore the We then explored the consequences of wage The growth of tax rates on earned income has problem of efficient taxation in the context of taxation in models which allowed for endo­ the uncertainty model. focused attention upon the impact of such genous first-period consumption and endo­ taxes on work effort. The effect of taxes on genous leisure, respectively. It was shown how In Part II, we begin by studying a very hours of work has been the subject of both the behavioural parameters in these more simple uncertainty model of human capital careful theoretical and econometric study. The complicated models interact with risk aversion accumulation, and contrast the tax implications basic lesson of the theoretical literature is that in order to determine how human capital with those which fall out of the corresponding the impact of taxation on hours of work is accumulation is influenced by the wage tax. certainty case. We then examine a number of logically indeterminate because of the familiar Finally, attention was focused upon the extensions of the basic model, and ascertain conflict between income and substitution problem of efficiently taxing an individual how they influence the tax sensitivity of human effects. Therefore, an enormous amount of whose human capital yields a random return. capital accumulation. It is shown that under econometric research has been done on this An interesting result emerged. Pure lump-sum reasonable assumptions, the impact of taxation subject. Although there is a disconcertingly taxation does not necessarily minimise excess upon human accumulation is very different high variance in estimates of labour supply burden. Given risk aversion, partial reliance from that which emerges from the certainty elasticities, it would probably be fair to say on a wage tax improves allocative efficiency model. that the consensus is that the response in because it reduces the riskiness of investment hours of work to changes in the net wage is Part HI discusses the problem of optimal in human capital. very small for prime age male earners. This wage taxation when the returns to human Our models are very simple, and there are a finding has been interpreted by some as evidence capital are uncertain. We show that under number of ways in which they could be that taxes have little influence on work effort. uncertainty the efficient wage tax may exceed extended. It would be interesting to analyse zero even when lump-sum taxation provides Without doubt, theoretical and econometric cases in which returns to non-human capital an alternative source of revenue. This finding work to refine estimates of the hours response are also stochastic. Study of models in which contrasts, of course, with the well-known to changes in the tax structure will continue in the random component affects the return to result from the optimal tax literature that, the future. However, it must be noted that human capital non-multiplicatively would also under certainty, lump-sum taxation provides "work effort" and "hours of work" are not be useful. Our guess, however, is that compara­ the most efficient means of raising revenue. synonymous. Even if taxes have little impact tive statistics results on the impact of taxes The difference arises because the market fails upon quantity of hours worked, it is possible from more complicated models will not yield to insure against the risk associated with that they have an important effect on the quality many new insights. If this paper is right in its human capital. The government via the wage of number of hours worked. Examination of assertion that the unambiguous results of the tax acts as insurer and thus increases welfare. the impact of taxation upon human capital certainty models do not generalise to the un­ We follow our discussion of the positive and accumulation may provide insight into the certainty case, then empirical work is probably normative aspects of taxing the returns to effect of taxes on work effort. the most fruitful way to carry on research of human capital with some summary remarks this important question. Not very much work has been done on inte­ and suggestions for future research in Part IV. The results of Part III suggest, furthermore, grating taxation into the analysis of human the value of additional theoretical analysis of capital. Boskin studies a model of individual lifetime earnings maximisation, and shows that the design of optimal tax systems. The familiar a proportional wage tax has no effect on human result that, under certainty, commodity or Summary and Conclusions income taxation is necessarily second best does capital accumulation. Heckman and Driffill Although optimal human capital accumulation not generalise to situations characterised by the note that income (as opposed to wage) taxes has been studied intensively, little attention has presence of uncertainty which is neither will change the optimal amount of human been devoted to the impact of taxes on the diversifiable nor insurable. The uninsurability of capital accumulation because they change net human capital decision. This paper has most investments in human capital suggests discount rates. These results are all obtained studied the effect of wage and income taxes on from models in which the returns to human that departures from lump-sum taxation may human capital using a model in which the be optimal more frequently than previously capital investment are known with certainty. returns to human capital investment are un­ realised. However, as Levhari and Weiss emphasize, un­ certain. We began by studying a simple two- certainty is of paramount importance in Our conclusions also have implications for period model in which leisure and first-period human capital investment decisions. Although optimal redistributive income taxation as consumption were exogenously determined. It the taxation of non-human capital in an un­ developed for the certainty case by Mirrlees, was shown that the well-known neutrality of certainty context has been studied extensively, Fair and Feldstein (1973), for example. It may wage taxation in such a model is broken when it will be explained below that results from this be the case, for instance, that introducing the returns to human capital are uncertain. literature do not carry over to the human uncertainty of the type hypothesized in our The tax decreases the risk associated with capital case. One of the main goals of this model will, ceteris paribus raise the optimal human capital investment tending to increase paper is to analyse theoretically the effect of marginal tax rate of more risk-averse income its desirability. At the same time wage taxation taxation on human capital accumulation in a groups. These issues are worth further inquiry. lowers wealth which reduces the demand for model which explicitly allows for uncertainty. human capital ceteris paribus when the degree The authors are on the staff of Princeton of absolute risk aversion is decreasing. The University, and their full paper is available as A closely related issue is that of the optimal Working Paper 117 from the Industrial overall effect depends upon the relative taxation of wage income. Previous studies of Relations Section, Princeton University, PO strengths of these two tendencies. Similarly, efficient wage taxation have treated returns to under uncertainty it is no longer the case that Box 248, Princeton, New Jersey 08540, USA. human capital as certain. However, to the an income tax unambiguously expands human extent that introducing uncertainty changes The synopsis is taken from a longer paper capital accumulation. Quite possibly, income behavioural responses to taxes, it may change to which the American Economic Review holds taxation will discourage human capital. optimal tax rates as well. A second major final editorial rights.

Journal

Management Research NewsEmerald Publishing

Published: Apr 1, 1979

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