Income Taxation in a Life Cycle Model with Human Capital

Michael Keane

This paper examines the effect of labor income taxation in life-cycle models where work experience builds human capital. In this case, the wage no longer equals the opportunity cost of time - which is, instead, the wage plus returns to work experience. This has a number of interesting consequences.

First, contrary to conventional wisdom, in such a model permanent tax changes can have larger effects on labor supply than temporary tax changes.

Second, even with small returns to work experience, conventional methods of estimating the inter-temporal elasticity of substitution will be very seriously biased towards zero.

Third, for plausible parameter values, both compensated and uncompensated labor supply elasticities are likely to be quite a bit larger than (conventional) estimates of the inter-temporal elasticity of substitution (despite the fact that the latter is typically viewed as an upper bound on the former).

Fourth, for plausible parameter values, large welfare losses from proportional income taxation are quite consistent with existing (small) estimates of labor supply elasticities.