Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

Abstract: We set up an OLG-model, where households both choose human capital investment and decide on investing their endogenous savings in a portfolio of riskless and risky assets, exposing them to (aggregate) wage and capital risks due to technological shocks. We derive the optimal public policy mix of taxation and education policy. We show that risks can be efficiently diversified between private and public consumption. This results hinges on that the government can apply a wide set of instruments, including differentiated wage and capital taxation. We also show that for sufficient risk aversion the (Northern) European way of relying on progressive wage taxation and granting education subsidies is an optimal response to wage and capital risks.

Keywords: Optimal Income Taxation; Multiple Income Risks; Human Capital Investment; Portfolio Choice

JEL-codes: H21; I28; J24

39 pages, September 22, 2008

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