Does the tax system encourage too much education?

Abstract

The Nordic countries have dual income taxation, with a proportional tax on capital income and a progressive tax on labour income. Nielsen and Sørensen (1997) argue that this asymmetric treatment of the two types of income can be defended on pure efficiency grounds. The progressivity of the labour income tax serves to reduce the private return to human capital investment, thereby offsetting the tendency of a proportional comprehensive income tax to discriminate in favour of such investments. They use a simple overlapping generations model in a small open economy. The consumer faces a trade-off between investments in financial and human capital, and education serves only as a means to shift consumption between periods. The present paper expands this model by including the intrinsic value of education as a motivation behind getting education. I find that the argument in favour of dual income taxation is strengthened. A comprehensive proportional income tax works as a tax subsidy on human capital investments, and it reduces the price of education as a consumption good. This may explain the puzzle why so many choose to get higher education in the Nordic countries, where the wage return to education is modest. By introducing a progressive labour income tax, the total return to education is reduced. Hence the efficiency distortion in the capital market may be partly neutralised.