Education, preferences for leisure and the optimal income tax schedule

This paper characterizes optimal income taxes and human capital policies in a two period Mirrlees economy. Agents, differentiated by their preferences at birth, invest in human capital not knowing in advance the returns of such investment. Clear cut prescriptions are not always possible even when we focus on specific assumptions about the relative importance of heterogeneity at birth and heterogeneity that arises later in life. Yet, we are still able to identify which combinations of policies are compatible with Pareto efficiency and which are not. With regards to implementation, income taxes that depend on an agent's schooling play a role in committing her to more restricted budget sets in the second period. This type of commitment is shown to improve agents' expected utilities. (C) 2007 Elsevier B.V. All rights reserved.