Optimal Capital Income Taxation with Endogenous Human Capital Formation∗

This paper analyzes optimal linear taxes on capital and labor incomes in a life-cycle model of human capital investment, financial savings, and labor supply with heterogenous individuals. A dual income tax with positive marginal tax rates on not only labor but also capital income is optimal. The key function of the tax on capital income is to reduce labor tax distortions on human capital accumulation. The optimal capital income tax is relatively lower than the labor income tax if: i) savings are relatively elastic compared to investment in human capital; ii) substitution between inputs in human capital formation is difficult; iii) most investments in human capital are verifiable and can be subsidized. Numerical calculations suggest that marginal taxes on capital income are substantially positive and roughly equal to marginal tax rates labor incomes.