How should redistributive governments change tax and education policy in response to skill- biased technical change? To answer this question, this paper merges the canonical model of skill-biased technical change due to Katz and Murphy (1992) with the continuous-type Mirrlees (1971) model. Workers of different ability face an extensive education choice to be come high-skilled. Wages are endogenous. Optimal marginal income tax rates follow the same formula as in Mirrlees (1971). The intercept of the optimal tax function differs for low-skilled and high-skilled workers, while marginal tax rates are the same for high-skilled and low-skilled workers at the cut-off ability where workers are indifferent between being high-skilled or not. We show that education should optimally be taxed on a net basis. Moreover, optimal tax and education policies do not exploit general-equilibrium effects on the wage distribution to reduce pre-tax earnings differentials. SBTC has ambigous effects on optimal marginal tax rates depending only on how social welfare weights change. SBTC has ambiguous effects on income net taxes on education, since distributional benefits and distortions simultaneously increase. Numerical simulations demonstrate that SBTC leads to higher optimal marginal income taxes for middle incomes, while lowering marginal income taxes towards the top. Skill-biased technical change raises optimal marginal income tax rates especially around the income level of the marginally high-skilled worker. The tax system becomes more progressive in response to SBTC. Education subsidies increase in response to SBTC.
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.