Bas Jacobs, Uwe Thuemmel
Publication year: 2018

This paper studies how tax and education policy should optimally respond to skill-biased technical change (SBTC). To do so, it merges the canonical model of SBTC (Katz and Murphy, 1992) and the optimal linear tax model (Sheshinski, 1972), which is extended with a discrete education decision. For a given level of skill-bias, the optimal income tax and education subsidy equate marginal distributional benefits to the marginal distortions in labor supply and education. Optimal income taxes are lower and optimal education subsidies are higher if general-equilibrium effects cause stronger wage compression. Skill-biased technical change (SBTC) has theoretically ambiguous impacts on both optimal income taxes and education subsidies, since SBTC simultaneously changes i) distributional benefits, ii) distortions in education, and iii) wage compression effects of both policies. The model is calibrated to the US economy to quantify the impact of SBTC on optimal policy. SBTC is found to make the tax system more progressive, since the distributional benefits of higher income taxes rise more than the tax distortions on education and the wage-decompression effects of taxes. SBTC also lowers optimal education subsidies, since the distributional losses and the distortions of higher education subsidies increase more than the wage-compression effects of subsidies.