When educational policy is supplemented by a redistributive income tax, and when individuals differ in their ability to benefit from education, the optimal policy is typically rather regressive. Resources are concentrated on the most able individuals in order to get a "cake " as big as possible to share among individuals through income taxation. In this paper we put forward another reason to push for regressive education. It is not linked to heterogeneity in innate ability to benefit from education but to pervasive non-convexities that arise in the optimal income tax problem when individual productivities are endogenous. For simplicity we assume a linear education technology and a given total education budget. To give the equal wage outcome the best chance to emerge, we also assume that individuals have identical learning abilities. Nevertheless, it turns out that in the first-best wage inequality is always preferable to wage equality. Even more surprisingly, this conclusion remains valid in the second-best (unless ad hoc restriction on the feasible degree of a wage differentiation are imposed). This is in spite of the fact that wage equalization would eliminate any need for distortionary income taxation.

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This paper extends the standard human capital model with real options. Real options affect investment behavior when risky investments in human capital are irreversible and individuals can affect the timing of the investment. Option values make individuals more reluctant to invest in human capital and required returns on the investment increase. Higher tax rates (or lower subsidies) depress human capi-tal investments, but to a lesser extent than in the standard human capital model. A flat income tax remains to be neutral if education expenditures are fully deductible. Real options may explain a large human capital premium, small responsiveness of human capital investments to financial incentives, large sensitivity of investment behavior to low-return outcomes and more delayed investment in human capital even when returns are high.

In this paper we characterize quantitatively the optimal mix of progressive income taxes and education subsidies in a model with endogenous human capital formation, borrowing constraints, income risk. and incomplete financial markets. Progressive labor income taxes provide social insurance against idiosyncratic income risk and redistributes after tax income among ex-ante heterogeneous households. In addition to the standard distortions of labor supply progressive taxes also impede the incentives to acquire higher education, generating a non-trivial trade-off for the benevolent utilitarian government. The latter distortion can potentially be mitigated by an education subsidy. We find that the welfaremaximizing fiscal policy is indeed characterized by a substantially progressive labor income tax code and a positive subsidy for college education. Both the degree of tax progressivity and the education subsidy are larger than in the current U.S. status quo.

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Despite using a variety of models and assumptions, the existing literature has overwhelmingly concluded that education policy should be regressive. In this paper, we examine a two-period model in which the government may impose non-linear taxes on both labour income and education expenditures. Individuals un-dertake education in the …rst period to increase their second-period wages. Our main result is that optimal education policy in our model is progressive. Speci-cally, if the government can commit, it is optimal for high-skill individuals to face a zero marginal tax rate on their education expenditures, while that for low-skill individuals is negative. If the government cannot commit, the optimal marginal tax rate on education expenditures by high-skill individuals is positive, while that for low-skill individuals remains negative.

We develop a model of education where individuals face educational risk. Successful graduation depends on individual effort to study and public resources. After realization of risk, they either work as skilled or as unskilled worker. We show that an optimal public policy consists of tuition fees combined with skill-contingent loans, lump-sum transfers/taxes, and public funding of the educational sector. We argue that improved educational opportunities matter more than direct income transfers in a Second-best setting. Contrary to standard models in case of income risk, it is not optimal to use a proportional wage tax, because skill-contingent loans and public education spending provide simultaneously insurance and redistribution at lower costs. A wage tax is only optimal, if tuition fees are not available.

We study a two-sector economy with investments in human and physical capital and imperfect labor markets. Investments are irreversible and noncontractible, due to random matching between firms and workers. Income is allocated according to the Nash bargaining mechanism. At equilibrium, given the distribution of the agents across sectors, there is underinvestment in both human and physical capital, due to the hold-up 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 little effort in the high-skill sector. We also study the effects of several tax policies on total expected surplus. K: Human capital; Efficiency; Labour income tax JEL classification: J24; H2

and seminar participants at various institutions and conferences for many useful comments. Krueger

An electronic version of the paper may be downloaded • from the SSRN website: www.SSRN.com • from the RePEc website: www.RePEc.org • from the CESifo website: Twww.CESifo-group.deT CESifo Working Paper No. 1890 ANALYZING A FLAT INCOME TAX IN