Human Capital and Optimal Redistribution

Review of Economic Dynamics 27 (2018) 1–26
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Review of Economic Dynamics

www.elsevier.com/locate/red
Human capital and optimal redistribution ✩

Winfried Koeniger a,∗ , Julien Prat b
a
University of St. Gallen (Swiss Institute for Empirical Economic Research), CESifo, CFS, IZA, Varnbuelstrasse 14, 9000 St. Gallen, Switzerland
b
CREST, CNRS, Université Paris-Saclay, BGSE, CEPR, CESifo, IZA, 5 avenue Henry Le Chatelier, 91120 Palaiseau, France
a r t i c l e i n f o a b s t r a c t
Article history: We characterize optimal redistribution in a dynastic economy with observable human
Received 15 September 2015 capital and hidden ability. We show that the wedge between human capital investment
Received in revised form 13 October 2017 in the laissez faire and the social optimum differs from the wedge for bequests because
Available online 19 October 2017
(i) returns to human capital are risky, and (ii) human capital may change informational
JEL classification:
rents. We compute the optimal allocation when ability is persistent across generations,
E24 as calibrated for the U.S. We show how the allocation can be implemented with student
H21 loans featuring contingent repayments. The quantitative results reveal that human capital
I22 investment should (i) increase in parental income because of ability transmission across
J24 generations, but (ii) decrease in inherited assets because of the negative effect of wealth
on labor supply.
Keywords: © 2017 Elsevier Inc. All rights reserved.
Human capital
Bequests
Optimal taxation
Asymmetric information
Intergenerational equity
Student loans
1. Introduction
Of all the factors shaping inequality, one of the most debated is the transmission of financial and human capital from
parents to their offspring. It is frequently argued that children from a privileged background get a head start that is difficult
to reconcile with the provision of equal opportunity. Yet, eliminating intergenerational inequality would be counterproduc-
tive since it would remove the motivation of parents to provide their children with wealth and education. The optimal
taxation of intergenerational transfers is therefore determined by the classic trade-off between insurance and incentives.
Mirrlees’ (1971) seminal contribution on optimal income taxation lays out a rigorous framework to analyze this trade-
off. It shows that asymmetric information about labor market productivity prevents full insurance because productive agents
would not find it optimal to reveal their ability. We build on Mirrlees’ insight, and the subsequent literature on optimal tax-
ation, to characterize efficient redistribution in a model with altruistic dynasties. Each working-age generation of a dynasty
decides how much labor effort to exert, how much to consume, to bequeath in terms of bonds and to invest into human
✩
We are grateful to Emmanuel Farhi and Iván Werning for making the code used in Farhi and Werning (2013) available, and to Carlo Zanella for excellent
research assistance. We thank the editor, anonymous referees, colleagues as well as participants in various seminars for very helpful comments. Part of this
research has been conducted while Winfried Koeniger was at Queen Mary, University of London; and Julien Prat was at the Institute for Economic Analysis
(CSIC). Julien Prat acknowledges the support of the LABEX Investissements d’Avenir (ANR-11-IDEX-0003/Labex Ecodec/ANR-11-LABX-0047).
*
Corresponding author.
E-mail addresses: winfried.koeniger@unisg.ch (W. Koeniger), julien.prat@ensae.fr (J. Prat).
https://doi.org/10.1016/j.red.2017.10.002
1094-2025/© 2017 Elsevier Inc. All rights reserved.
2 W. Koeniger, J. Prat / Review of Economic Dynamics 27 (2018) 1–26
capital of their offspring. Bequests and human capital are observable (think of years of schooling, high-school or college
degrees) but the draw from the ability distribution, and hence productivity, is private information.
We show how taxes on labor income and bequests distort human capital investment. Thus, education and tax policies
need to be jointly determined. Following the optimal taxation literature, we use the wedges between the laissez faire and
the social optimum to characterize the implicit taxes or subsidies required to attain the social optimum.
The constrained-efficient wedge for human capital turns out to be closely related, but not identical, to the wedge for
bequests. The similarity is intuitive because parents can substitute financial with human capital when they transfer resources
to their offspring. But the future labor market productivity of children is uncertain and parents cannot insure against this
risk, making it less attractive for families to invest in human capital if it provides a bad hedge against consumption risk.
The planner then does not have to discourage human capital investment to the same extent as bequests.
The planner also takes into account the impact that education has on the trade-off between equality and incentives.
Intuitively, if talented agents benefit more from human capital investments, increasing education raises their informational
rents and worsens the incentive problem. This is why the wedge for human capital also depends on the complementarity
between ability and human capital.
We provide quantitative results for a persistence of ability across generations that is calibrated to match the intergenera-
tional earnings elasticity observed for the U.S. In accordance with Mincer’s specification of the wage equation, we postulate
a unit elasticity between ability and human capital. We find that the wedge for human capital required to implement the
constrained-efficient allocation is much lower than the wedge for bequests, so that human capital is often subsidized while
bequests should be taxed across all income levels.
Strikingly, our results suggest that the socially-optimal investment into children’s human capital should be increasing in
parental income but decreasing in parental wealth. The effect of parental income is explained by the positive correlation
of income and ability together with the persistence of ability across generations. Higher income thus implies a higher
expected ability of the children, making it optimal to provide these children with more human capital. Quantitatively this
effect dominates the reduction in the labor supply of children of high-income parents due to the fact that they inherit
larger bequests, which makes it relatively less efficient for the planner to invest into their human capital. This negative
wealth effect explains why higher parental wealth reduces optimal human capital investment and is empirically plausible:
Holtz-Eakin et al. (1993) document that the receipt of an inheritance reduces labor force participation, and Brown et al.
(2010) provide evidence that it increases the probability of retirement.
We also illustrate how the social optimum can be implemented using loans with contingent repayments. In particular,
we describe how contributions to education costs should be designed to implement the social optimum, for a given stylized
representation of the U.S. income tax schedule. This experiment shows that the social optimum can be implemented by
optimal design of education finances alone. It does not require a politically infeasible reform of the whole tax system
because it relies on instruments that resemble actual repayments schemes. Given the redistribution implied by income
taxes in the U.S., we find that income-poor families should be recipients of net education subsidies whose size decreases
more rapidly in income if they have less inherited wealth.
A technical contribution of the paper is that we solve for optimal education and tax policies assuming shocks to ability
that are persistent but not permanent. Persistence of ability shocks in our intergenerational model allows us to match the
observed intergenerational earnings elasticity. This comes at the cost of a larger state space.1 We reduce the computational
burden by developing an efficient algorithm, based on the endogenous gridpoint method in Hintermaier and Koeniger
(2010), to solve the decentralized problem of dynasties that we use for the calibration.
Related literature. Our paper relates to the two large literatures on human capital and optimal taxation. For brevity, we
focus only on a few recent contributions and refer to their literature reviews as well as the special issue on human capital
and inequality edited by Corbae et al. (2017) and the volume on inequality and redistribution of the Carnegie-Rochester
Conference Series (2016) for further discussion of previous research.
While the wedges for labor supply and bequests in our model correspond to previous findings in the literature (Farhi
and Werning, 2013; Golosov et al., 2011; Kapička, 2013; Kocherlakota, 2010; Saez, 2001; and references therein), the wedge
for human capital provides novel insights. It differs from the wedge for bequests because human capital carries more risk
than bequests and, as explained above, may change the power of incentives.
Our results relate to recent research on optimal redistribution and human capital accumulation over the life cycle.
Findeisen and Sachs (2016a) and Gary-Bobo and Trannoy (2015) analyze optimal student-loan contracts in asymmetric-
information models with two periods. They show that the socially optimal allocation can be decentralized with student
loans that have income-contingent repayment schedules. From a technical point of view, Findeisen and Sachs (2016a) use
the generalized envelope condition derived by Kapička (2013) and Pavan et al. (2014) to characterize the planner’s necessary
conditions, as we do in this paper.
Stantcheva (2016) extends the analysis of Findeisen and Sachs (2016a) to a multi-period setting with training time.
She proposes a decomposition of the human capital wedge that is similar, but not identical, to ours. The discrepancy
arises because of her focus on a life-cycle problem in which human capital raises today’s productivity, which generates
1
With permanent ability shocks it is possible to reduce the number of state variables by defining the problem in units of permanent ability.
W. Koeniger, J. Prat / Review of Economic Dynamics 27 (2018) 1–26 3
a close relationship between the human capital wedge and the contemporaneous labor wedge. This is different in our
intergenerational model in which the benefits of children’s education accrue only next period, when these children become
adults and participate in the labor market. This natural difference in timing in our dynastic family model generates a close
relationship between the wedge for human capital and the intertemporal wedge for bequests.
The results in our model also have a different interpretation because we are focusing on dynastic families. This relates
our analysis to recent papers on optimal redistribution across generations. Gelber and Weinzierl (2016) analyze optimal
taxation when the ability of future generations depends on the resources of the current generation. This is modeled by
letting the probability of types directly depend on disposable income. Our model shares the feature that current resources
may impact the earnings capacity of future generations but lets generations choose the amount of resources allocated to
human capital accumulation.
Bohaček and Kapička (2008) characterize optimal education and tax policies when agents have heterogeneous ability that
remains constant over time. Kapička (2006, 2015) and Kapička and Neira (2015) extend this analysis by focusing on human
capital investment or learning effort that are unobservable. If not all expenditures on human capital are verifiable, Jacobs
and Bovenberg (2010) show that capital taxes can mitigate the distortionary effects of labor income taxation on human
capital investments. By contrast, our assumptions of observable human capital and stochastic unobserved ability allow us to
characterize the wedge for human capital when ability is not perfectly predictable across generations.
The complementary research by Erosa and Koreshkova (2007), Heathcote et al. (2016), Krueger and Ludwig (2016),
Lee and Seshadri (2014), Peterman (2016) and Stantcheva (2015), Sections 2–5, does not use the Mirrlees approach to
analyze the effect of redistribution in models with human capital accumulation. Following the Ramsey approach, they
specify parametric tax schedules and then analyze the welfare effects of changes in taxes. Building on this approach, Abbott
et al. (2016) emphasize that more generous grants for education may crowd out intergenerational transfers.
Finally, our finding that the planner can change the equality-efficiency trade-off over time by adjusting the amount of
human capital is akin to the economic mechanism in Koehne and Kuhn’s (2015) model with habits or durable consumption.
In their paper, the planner can exploit complementarities between durable and non-durable consumption choices over time
to raise the marginal utility of non-durable consumption and thus the incentive to exert labor effort. Our paper shows how
education may reduce the disutility of labor of future generations if human capital is not too complementary to innate
ability. Then, consumption of leisure is less attractive and incentives to exert effort are stronger.
The rest of the paper is structured as follows. In Section 2 we describe the set-up of the model and solve the planner’s
problem. In Section 3 we derive the optimality conditions in the laissez faire and then characterize the wedges between the
laissez faire and the social optimum. We present the numerical solution for a calibrated version of the model in Section 4
and discuss implementation of the constrained-efficient allocation in Section 5.
2. The model
2.1. Set-up
Family dynasties are the decision units of our analysis. Each family is composed of parents and children in each genera-
tion, has a planning horizon T and a size normalized to one. The family chooses the labor supply of the parents, as well as
the bequests and education for the children. Preferences link generations in a time separable fashion. We make the common
assumption that the per-period utility function U (ct , lt ) is separable in consumption ct and labor effort lt :
[A1] : U (ct , lt ) = u (ct ) − v (lt ) ,

u (ct ) ∈ C 2 (R+ ) is increasing in ct and strictly concave,
v (lt ) ∈ C 2 (R+ ) is increasing in lt and strictly convex.
Agents differ in their ability θt which cannot be observed by the planner. Instead, both bequests bt and human capital
ht ∈ R+ are public knowledge. Output yt is produced according to the technology Y (ht , lt , θt ) which is increasing in its
arguments, concave and bounded below by zero. We will use the production function to substitute lt in the utility function
and write U (ct , yt , ht , θt ) instead of U(ct , lt ) or, with assumption [A1], v ( yt , ht , θt ) = v (lt ). Note that the planner cannot use
observable output yt to infer actual labor supply lt because ability θt is stochastic and hidden.
In the spirit of Ben-Porath (1967), human capital in the next period ht +1 depends on the expenditure flow for education
et and on the family background, which can be summarized by the stock of human capital of parents ht . The human capital
production function ht +1 (et , ht ) is increasing in its arguments.2
The timing of the model is as follows. In any given period t, the family learns the parents’ type θt and chooses to
spend et on the children’s human capital ht +1 , to supply parents’ labor lt , to consume ct and thus bequeath bt +1 . Labor
2
We abstract from time use for human capital investments into children because the time effort exerted for human capital accumulation is plausibly as
unobservable as is the time effort for production. Adding a second hidden action renders the analysis much less tractable because it enables agents to use
joint deviations. Furthermore ht +1 does not depend on the children’s realized ability θt +1 . This assumption could be relaxed but is imposed for parsimony:
allowing ht +1 to depend on θt +1 would add a channel through which output depends on ability but would not add substantial insights to our analytical
and numerical results, as long as observation of ht +1 does not allow the planner to infer θt +1 .
market productivities are drawn at the beginning of each period from the interval ≡ [θ, θ] ⊂ R+ according to a con-
tinuously differentiable distribution F : → [0, 1] with conditional density f ( θt | θt −1 ). We assume for technical reasons
that f ( θt | θt −1 ) has full support, that it is of class C 2 with respect to its second argument θt −1 and that this derivative
is bounded, i.e., |∂ f ( θt | θt −1 ) /∂θt −1 | ≤ B for some B ∈ R+ . Letting the distribution F ( θt | θt −1 ) depend on the type of the
previous generation enables us to capture the intergenerational transmission of ability which may occur either because of
genetic inheritance or nurture in early childhood. We will calibrate in Section 4 the correlation between θt and θt −1 so as
to match the intergenerational correlation of earnings observed in U.S. data.
2.2. The planner’s problem
Incentive compatibility. According to the revelation principle, we can solve for the social optima by focusing on a direct
revelation mechanism such that families truthfully report their types in each generation. Let θ t ≡ {θ0 , θ1 , ..., θt } denote the
history of types within a given family. We do not impose
any arbitrary
restrictions on the allocation. In particular, we do
not rule out history dependent schemes xt θ t ≡ ct θ t , ht +1 θ t , yt θ t . Hence the feasible set X contains all sequences
T
x ≡ xt θ t t =1
of measurable functions xt : t → R3+ . The family’s preferences over an allocation x are given by
T
t t t −1
t −1
U (x) ≡ E0 β U c t θ , y t θ , ht θ , θt ,
t =1
where E0 is the expectation operator conditional on information available at time 0 and β is the discount factor measuring
the strength of the altruism towards future generations.
T
In general, families do not have to behave truthfully. They can choose any reporting strategy r ≡ rt θ t t =1 from the set
R containing all sequences of measurable functions rt : t → . Since types are private information, an allocation must be
incentive compatible, i.e.,
( I C ) : U (x) ≥ U (x ◦ r) , for all r ∈R, (1)

T
where (x ◦ r) θ t ≡ xt r t θ t t =1
is the allocation x resulting from the reporting strategy r and history θ t .
In order to write the planner’s problem in a recursive form, we replace the ex-ante incentive constraint (1) with an
ex-post requirement. For this purpose, we define the equilibrium continuation utility ω θ t for a given history θ t as

ω θ t ≡ U ct θ t , yt θ t , ht θ t −1 , θt + β ω θ t , θt +1 dF ( θt +1 | θt ) , (2)

for all t = 1, ..., T , and ω θ T +1 = 0 because each dynasty has horizon T . At the beginning of period t, families compare
t
the continuation value ω θ of truthful reporting to those derived from arbitrary reporting strategies

ωr θ t ≡ U ct rt θ t , yt rt θ t , ht rt −1 θ t −1 , θt + β ωr θ t , θt +1 dF ( θt +1 | θt ) , (3)

T +1

with r
ω θ = 0. Ex-post incentive compatibility is ensured when

ω θ t ≥ ωr θ t , for all θ t and all r ∈R. (4)
We use xIC to denote the set of all allocations x satisfying (4).3
Planner’s objective. The planner discounts future utility with the factor q which equals the inverse interest factor.4 As Farhi
and Werning (2013), we abstract from general equilibrium feedbacks so that the allocation problem can be analyzed sepa-
rately for each family. The expected costs of an allocation, for a given θ0 , are given by
3
Note that allocations in xIC are incentive compatible for all θ t ∈ t . Thus we now require truth telling to be optimal after any history of shocks, whereas
the incentive constraint (1) only requires truth telling to be ex-ante optimal. As shown by Theorem 2.1 of Fernandes and Phelan (2000), the two notions
can only differ on a set of measure zero histories. In other words, allocations that are ex-ante incentive compatible are also ex-post incentive compatible
almost everywhere. See also Lemma 1 in Kapička (2013) for the case with persistent stochastic ability.
4
We assume that the planner maximizes the welfare of the initial dynasty as in the infinite-horizon setting of Atkeson and Lucas (1992). See Farhi
and Werning (2007, 2010), Phelan (2006) and Kocherlakota (2010), chapter 5, for analyses in which the planner may give additional weight to future
generations. As shown in Farhi and Werning (2010), section IV.C, this generates a motive to subsidize education even when the labor supply of the next
generation does not depend on human capital. We deliberately neutralize this motive in order to isolate the impact that human capital has on the incentives
to exert labor effort.
T
t t t
t −1
(x) ≡ E0 q ct θ + et θ − y t θ ,
t =1
and an allocation is efficient when it minimizes the costs of delivering a certain utility
min (x) , (5)

x∈X
s.t. (i ) U (x) ≥ V ; (ii ) x ∈ xIC .

Condition (i) is the promise-keeping constraint which ensures that the expected utility of truthful families is at least as high
as the exogenously given level V , while condition (ii) excludes all the allocations that are not incentive compatible.
First-order approach. Problem (5) requires to keep track of all the out-of-equilibrium payoffs in order to check the incen-
tive constraint (4). We circumvent this issue by replacing the incentive constraint with an envelope condition which only
depends on the marginal utility of truthtellers.
This necessary condition can be heuristically derived considering the following one shot deviations.5 For a given history
θ , let us define the set of strategies rσ ,t , indexed by σ ∈ and t ∈ {1, ..., T }, such that agents are truthful in all previous
t
and future periods but report σ in period t whatever is their actual type:

θs for s
= t ,
r σ ,t θ s =
s
σ for s = t .
Due to the Markov property of θ , next period continuation utilities only depend on the report and not on the actual type
σ ,t t
of the family, hence ωr θ , θt +1 = ω θ t −1 , σ , θt +1 . Reinserting this equality into (3), we see that incentive compatibility
requires that
σ ,t t
ω θ t = max ωr θ (6)
σ
⎧ ⎫
⎨ ⎬

= max U ct θ t −1 , σ , yt θ t −1 , σ , ht θ t −1 , θt + β ω θ t −1 , σ , θt +1 dF ( θt +1 | θt ) .
σ ⎩ ⎭

Differentiating (2) and using (6), we obtain the following envelope condition6

∂ω θt ∂ U ct θ t , yt θ t , ht θ t −1 , θt ∂ f ( θt +1 | θt )
= + β ω θ t +1 dθt +1 . (7)
∂θt ∂θt ∂θt

When types are i.i.d., the integral on the right-hand side of (7) vanishes and we recover the condition prevailing in Mirrlees’
static setting. The additional term is relevant when types are persistent because then unobserved ability generates additional
private information. Parents who misreport their type not only affect their current payoff U , but also drive a wedge between
their expectation and that of the planner. For example, underreporting with positively correlated types implies that parents
become more optimistic than the planner about the ability of their children.
Relaxed problem. Replacing the incentive constraint by (7) greatly simplifies the optimization problem because it now only
depends on the continuation utility of truthtellers instead of that of all possible types. If we denote by xFOA the set of
allocations such that condition (7) holds for all θ t , we have xIC ⊆ xFOA and the following problem is a relaxed formulation
of the original objective defined in (5)
min (x) , (8)

x∈X
s.t. (i ) U (x) ≥ V ; (ii ) x ∈ xFOA .

We explain in Appendix A how to write (8) in recursive form so as to solve it through a sequence of standard optimal
control problems. The envelope condition (7) is only necessary. Its validity can be checked ex-post, by taking the allocation
resulting from the relaxed problem as given and verifying that solving the dynasty’s problem yields the same utility as the
one intended by the planner.7
5
See Kapička (2013) for a formal derivation in the general case with persistent stochastic ability.
6
The envelope condition (7) applies because problem (6) satisfies the conditions of Theorem 2 in Milgrom and Segal (2002).
7
See example 1 in Battaglini and Lamba (2014) with discrete types, as in any numerical approximation, or Farhi and Werning (2013), section 2.2.4, for
a discussion of the numerical procedure. Theoretical results about the sufficiency of the first-order approach with persistent shocks have been derived by
Kapička (2013) and Pavan et al. (2014). Note that sufficiency is easy to check when ability is i.i.d. because preferences satisfy the single-crossing condition.
Then the first-order approach is valid when the allocation is monotone in ability.
2.3. Optimality conditions
In the first best allocation, families are fully insured against changes in ability. Consumption remains constant across
agents and is therefore separated from production. With information asymmetries, perfect insurance is precluded because
the planner faces an insurance-incentive trade-off. We relegate the formal analysis of the planner problem, including the
derivation of the optimality conditions as well as the proofs for the subsequent results, to Appendix A. We now discuss the
optimality conditions for consumption and human capital and refer to Appendix A for the standard optimality condition for
output (A.11). For ease of notation, we shall henceforth use a prime “ ” to denote next period realizations and an underscore
“_” to denote a realization in the last period.
Remark 1. Under assumption [A1], the first-order conditions of the relaxed problem (8) imply that the reciprocal Euler
equation holds as

1 q 1
du (c (θ))
= E du (c (θ ))
.
β
dc (θ ) dc (θ )
The reciprocal Euler equation implies that the inverse of the marginal utility of consumption follows a martingale when
the planner and family share the same discount factor, i.e., when q = β . This well known feature of optimal tax systems
continues to hold when human capital accumulation is taken into account. Turning our attention to education, we find that
its accumulation should be governed by the following optimality condition.
Proposition 1. Let g (h , h) denote the cost of acquiring education h . If [A1] holds, the first-order condition with respect to human
capital of the relaxed problem (8) reads
⎛ ⎞
∂ v y (θ ),h (θ ),θ
∂ g (h (θ), h) ⎝ ∂ h (θ ) ∂ g (h (θ ), h (θ)) ⎠
= −q du (c (θ ))
+ dF θ θ (9)
∂ h (θ) ∂ h (θ)
dc (θ )

∂ 2 v ( y (θ ), h (θ), θ )
+q μ θ dθ ,
∂θ ∂ h (θ)

where μ (θ) is the costate variable of the planner’s problem
θ
∂ f ( x| θ− )/∂θ− 1
μ (θ) = λ+γ − f ( x| θ− )dx, (10)
f ( x| θ− ) du (c (x)) /dc (x)
θ

with limθ→θ μ (θ) = limθ→θ μ (θ) = 0. λ = E [du (c (θ)) /dc (θ)]−1 is the multiplier associated with the promise-keeping con-
straint (A.2), and γ is the multiplier associated with the threat-keeping constraint (A.3).
The marginal cost of human capital investment on the left hand side of (9) is equated to the marginal benefit. The latter
is made of three components. Firstly, human capital lowers the disutility of labor to produce a given quantity of output. This
allows the planner to spend less on consumption and still provide the family with the same continuation value.8 Secondly,
when education costs vary with the family background, so that ∂ g (h , h )/∂ h < 0, more investment reduces the cost of
accumulating human capital for the next generation. Thirdly, human capital affects the incentive compatibility constraint, as
captured by the second integral on the right hand side of (9). This term is central to our analysis so that we elaborate on it.
In the absence of informational frictions, families are perfectly insured against transitory shocks to ability and so
∂ ω (θ) /∂θ = 0. With hidden types instead, equation (7) and assumption [A1] imply that information revelation is profitable
solely if

∂ ω (θ) ∂ v ( y (θ) , h, θ) ∂ f θ θ
=− +β ω θ dθ . (11)
∂θ ∂θ ∂θ

∂ v y (θ ),θ ,h (θ ) ∂ u c θ
8
As shown in Appendix A, this benefit for the planner is captured by − ∂ h (θ ) / ∂ c (θ ) > 0.
The continuation utility is thus increasing in ability if the first and second term are positive. The first term is positive under
the assumption that higher ability reduces the disutility of effort, i.e., ∂ v (·)/∂θ < 0. The second term can be rewritten as9

∂ f θ θ /∂θ ∂ f θ θ /∂θ
β ω θ
f θ θ dθ = β Cov ω θ , ,
f ( θ | θ) f ( θ | θ)

which is positive if both the likelihood ratio ∂ f θ θ /∂θ / f θ θ and the continuation value are increasing in θ .
A likelihood ratio that increases in θ implies that the planner is more likely to observe higher future output for dynasties
that have high current ability, and that this effect is stronger for higher θ .
Incentive compatibility then prevents full insurance: children with more able parents enjoy higher lifetime utilities.
Human capital may influence incentive compatibility through the first term in (11). An increase in the slope |∂ v (·)/∂θ| of the
disutility term widens the gap separating the constrained-efficient allocation from the first best. Hence, the cross-derivative
∂ 2 v (·)/(∂θ∂ h) measures the effect that human capital has on the incentive compatibility constraint: if ∂ 2 v (·)/(∂θ∂ h) > 0,
more human capital reduces the informational rents and mitigates the incentive problem.
These gains are translated into consumption units through multiplication by the costate variable μ θ which mea-
sures the marginal cost of violating the incentive constraint. The resulting products in (9) are integrated over all potential
realizations of θ because neither the planner nor the family know the value of θ when the investment decision is made.10
The sign of the cross derivative ∂ 2 v (·)/(∂θ∂ h) is determined by (i) the elasticity ε vl of the marginal disutility of labor
with respect to changes in labor supply (which is inversely related to the Frisch elasticity of labor supply), and (ii) the
Hicksian coefficient ρhθ of complementarity between human capital and ability. Both are captured by a single parameter if
we assume functional forms for the disutility of labor and the production function for output as specified in the following
corollary.
Corollary 1. The effect of human capital on information rents is determined by

∂ 2 v ( y , h, θ)
sgn = sgn (1 + ε vl + 1 − ρhθ ) .
∂θ∂ h
Assuming that
[A1’]: U (c , l) = u (c ) − v (l) , where v (l) = ζ lα , with ζ > 0 and α > 1,

[A2]: Y (h, l, θ) = A (θ, h) l,
with A (θ, h) = [ξ θ χ + (1 − ξ ) hχ ]1/χ , χ ∈ (−∞, 1] and ξ ∈ (0, 1) ,
ε vl = α − 1 and ρhθ = 1 − χ so that ∂ 2 v ( y , h, θ)/ (∂θ∂ h) ≥ 0 if and only if χ ≥ −α .
If the production function is Cobb–Douglas, χ = 0. Hence, negative χ imply more complementarity between ability and
human capital than in the Cobb–Douglas case. Corollary 1 shows that informational rents are decreasing in human capital
when the sign of χ + α is positive: that is when the parameter α , which is inversely related to the Frisch elasticity of labor
supply,11 is greater than the degree of complementarity χ between ability and human capital.
Thus the effect of h on the informational rents enjoyed by high-ability families depends on two, potentially opposite,
channels. The first one is driven by the adjustment in labor supply following an increase in human capital. Raising h ensures
that any level of output can be produced with less labor. Since the disutility of effort is convex, the returns to ability, and
thus the informational rents, are reduced. This labor supply effect is unambiguously positive, in the sense that it relaxes the
incentive constraint, and its size is proportional to the convexity of v (·), as measured by the elasticity parameter α .
The second effect depends on the technology of production Y (·). When human capital and ability are complementary
factors, families with a high ability benefit more from any given increase in human capital. They find it more attractive to
imitate less able agents, which raises their informational rents. This is why an increase in the degree of substitutability, as
measured by an increase in the parameter χ , relaxes the incentive constraint, thereby reinforcing the positive influence of
the labor supply channel.

9
Since the changes ∂ f ( θ θ)/∂θ in the density have to sum to zero across all θ ,
⎡ ⎤

∂ f ( θ θ ) ∂ f ( θ θ )
∂ f ( θ θ )
E⎣ ∂θ ⎦= ∂θ
f ( θ θ )dθ = d θ = 0.
f ( θ | θ ) f ( θ | θ ) ∂θ

10
According to its definition in (10), the costate variable μ θ already includes the probability weight for each type.
11
The Frisch elasticity of labor supply is equal to 1/(α − 1).
3. The wedges
We now compare the optimality conditions in the laissez faire to those of the constrained-efficient allocation derived in
the previous section. The wedges between these conditions characterize the implicit taxes or subsidies which are necessary
to attain the social optimum.
In the laissez faire each family solves the maximization problem12
⎧ ⎫
⎨ ⎬
W (b, h, t ) = max U (c (θ), l(θ)) + β W b (θ), h (θ), t + 1 dF ( θ| θ− )
{b (θ ),h (θ ),l(θ ),c (θ )} ⎩ ⎭

s.t. b (θ) = (1 + r )b − c (θ) − e (θ) + y (θ),
y (θ) = Y (h, θ, l(θ)),
h (θ) = h (e (θ), h) so that e (θ) = g (h (θ), h),
where b is the bequest and the agent chooses functions b , h , l, c : → R.
Remark 2. The laissez faire is characterized by the following first-order conditions for bequests, human capital and labor
supply:

∂ U (c , l) ∂ U c , l
= β(1 + r )E ,
∂c ∂ c

∂ g (h , h) ∂ U (c , l) ∂ y ∂ g (h , h ) ∂ U c , l
= βE − ,
∂ h ∂c ∂ h ∂ h ∂ c
∂ U (c , l) ∂ y ∂ U (c , l)
− = .
∂l ∂l ∂c
We assume preferences and technologies for production and human capital accumulation such that the conditions in
Remark 2 are necessary and sufficient.13 Then the conditions in Remark 2 can be combined with the social-optimality
conditions (A.10)–(A.12) in Appendix A to derive interpretable expressions for the wedges between the choices in the laissez
faire and the constrained-efficient allocation of the planner. We start with the following definition.
Definition 1. The wedges for bequests τb , labor supply τl and human capital τh are
q du (c ) /dc
τb θ t ≡ 1 − , (12)
β E [du (c ) /dc ]
∂ v ( y , h, θ)/∂ y
τl θ t ≡ 1 − , (13)
du (c ) /dc
⎡ ⎤
du c
t β ∂ y ∂ g (h , h )
τh θ ≡ ∂ g (h ,h) E ⎣ du(c)
dc
− ⎦ − 1. (14)

∂ h ∂ h
∂h dc
Wedges are defined as the deviations

from the laissez faire. In general, the wedges depend on the whole history of
shocks since the allocation c , h , y is a function of θ t . In the following we simplify notations by denoting the wedges as

τ j ≡ τ j θ t , for j = b, h, l. They have a useful interpretation: constrained efficiency requires that the planner discourages
(encourages) bequests, labor supply or human capital, respectively, if the optimality conditions which characterize the social
optimum are such that τ j > 0 (τ j < 0), j = b, h, l.
Bequest and labor wedges. Combining the conditions for the social optimum with the definition of the wedges allows us to
derive the wedges at the constrained-efficient allocation. We first characterize the standard wedges for bequests and labor
supply which we also obtain in our model with human capital.
12
The first-order conditions of this problem are equivalent for the problem W L (b(θ), h(θ), θ, t ) = max{b (θ ),h (θ ),l(θ ),c (θ )} {[U(c (θ), l(θ)) +
$ L
β W (b (θ), h (θ), θ , t + 1)]dF (θ |θ)}, s.t. the constraints.
13
Note that human capital is chosen for the next generation (current human capital is a state variable) and thus does not imply a direct intratemporal
substitution effect for the labor supply of the current generation. This timing assumption, which is plausible in our setting with families who invest into the
education of their children, avoids the potential non-concavities discussed in Bovenberg and Jacobs (2005), Section 2.2. We have not been able, however, to
derive simple conditions that establish concavity in our dynamic model with the additional bequest choice.
Remark 3. Under assumption [A1], the first-order conditions of the planner’s problem imply that the constrained-efficient
wedges for bequests τb∗ and labor τl∗ are given by
1
τb∗ = 1 −
, (15)
E 1

du c E dudc(c )
dc
∂ 2 v ( y , h, θ) μ (θ)
τl∗ = − . (16)
∂θ∂ y f ( θ| θ− )
By Jensen’s inequality, we obtain the standard result that the wedge for bequests τb∗ > 0. The planner reduces intergen-
erational transfers to discourage double deviations in which parents leave bequests and their children shirk. The expression
for the labor wedge τl∗ is also standard. Since ability increases productivity, ∂ 2 v ( y , h, θ)/(∂θ∂ y ) < 0, and τl∗ is positive
whenever μ (θ) > 0. The families do not internalize that an additional unit of output tightens the incentive compatibility
constraint, which increases the information rents and thus allows for less redistribution.14
Human capital wedge. Our contribution consists in deriving an explicit decomposition for the optimal human capital wedge.
Proposition 2. Under assumption [A1’] and [A2], the constrained-efficient wedge τh∗ for human capital can be decomposed as
τh∗ = b + i ,
where

q ∂ y ∂ g (h , h ) τb∗ β du c ∂ y ∂ g (h , h )
b ≡ ∂ g (h ,h) E − + Cov , − , (17)

∂ h ∂ h 1 − τb∗ ∂ g (h ,h) du (c ) dc ∂h ∂ h
∂h ∂ h dc
and
⎡

⎤
∂ A θ ,h ∂ A θ ,h θ
q
dv l θ μ
⎣
i ≡ − ∂ g (h ,h) χ E l θ ∂θ ∂h ⎦. (18)
f ( θ | θ)
∂ h
dl A (θ , h )2
The first component b relates the wedge for human capital to the wedge for bequests τb∗ . It should not be surprising
that the two wedges are closely related since both forms of capital transfer resources from one generation to the next. The
first term in b is of the same sign as τb∗ .15 The equality
⎡ ⎤
du c
τb∗ dc
q = E ⎣β − q⎦
1 − τb∗ du (c )
dc
makes explicit that the size of qτb∗ /(1 − τb∗ ) depends on the difference between the stochastic discount factor of the family,

du c
β / dudc(c) , and the discount factor of the planner, q. The two discount factors differ because the reciprocal (not the
dc
standard) Euler equation holds at the social optimum. As τb∗ ∈ (0, 1), the difference is expected to be positive. In order
to correct that distortion, the planner has to render human capital accumulation less attractive. Otherwise families would
invest too much into human capital as an alternative way of transferring utility from the current to the future generation.16
However, bequests and human capital are not perfect substitutes because the return to human capital depends on future
ability and is thus risky. The risk adjustment is captured by the second term in (17) which depends on the covariance
between the return to human capital and the marginal utility of consumption. Since the return to human capital and
consumption of the next generation are both likely to increase with ability θ , we expect the covariance to be negative.
The planner needs to discourage human capital investment relatively less than bequests because the former provides a bad
hedge against consumption risk, rendering its accumulation less attractive to families.
The second component i corresponds to the incentive term in (9) net of the labor supply effect discussed at the end of
Section 2.3. We show explicitly in the proof of Proposition 2 that the effect on the incentive constraint through changes in
labor supply is exactly offset at the social optimum by the distortion of the human capital decision introduced by the labor
14
In Corollary 2 and its proof in Appendix A we elaborate on the labor wedge and mention that it is analogous to standard results in the literature.
15
To see why, notice that: (i) the return to human capital, ∂ y /∂ h − ∂ g (h , h )/∂ h , is positive; (ii) equation (15) implies that the constrained-efficient
wedge for bequests τb∗ ∈ (0, 1).
16
In other words, the component of the wedge b is positive if the risk-adjusted return to human capital investment is higher for families than for the
planner. See also the expression for b in equation (A.15) in the proof of Proposition 2.
Fig. 1. Illustration of perturbation h > 0 with Cobb–Douglas productivity (χ = 0).
wedge. On the one hand, the labor wedge reduces labor supply and thus the incentive to accumulate human capital. On the
other hand, less labor supply reduces the information rents because the disutility of labor, which depends on unobserved
ability, is lower and less convex. Hence, human capital accumulation needs to be discouraged less. The planner neutralizes
these intratemporal distortions for the human capital decision so that the socially optimal investment in human capital
differs from the laissez faire only because of the intertemporal distortions. This is why the decomposition in Proposition 2
does not contain a component relating the human capital wedge to the labor wedge. As in Stantcheva (2016), i can be
interpreted as the net wedge because it captures the implicit tax on human capital once the distortions introduced by the
wedges for bequests and labor have been compensated for.
When the parameter χ = 0, the production technology is Cobb–Douglas and the net wedge i = 0. To understand why,
it is instructive to rewrite the planner’s optimality condition as17

q ∂ y ∂ g (h , h )
1= E − − i . (19)
∂ g (h ,h) ∂ h ∂ h

∂h
Dividing (19) by q shows that the planner equates the social return on bequests 1/q to the social return on human capital.
As stated in Friedman (1962), p. 105, the planner makes “capital available at comparable terms for human and physical
investment.” If i = 0, the necessary condition for human capital (19) corresponds to the one prevailing in first-best envi-
ronments: the planner simply equates the marginal costs and returns of human capital investment.
Fig. 1 illustrates why incentive provision does not distort the planner’s optimality conditions when the technology is
Cobb–Douglas. The formal foundations for Fig. 1 are derived in the online Appendix B. The concave curves in the figure
illustrate a typical allocation in the y , u (c ) + β V plane. The convex curves are the indifference curves of a representative
family. Local incentive compatibility holds when the indifference curve is tangent to the allocation. Fig. 1 also reports the
effect of a perturbation which increases human capital and output holding labor supply, consumption and promised utility
constant. The allocation resulting from such a perturbation remains incentive compatible because both curves shift and tilt
in such a way that incentive compatibility is maintained. The planner can therefore set human capital so as to maximize
revenues without affecting the incentive compatibility of the allocation.
Further intuition for this result can be obtained by observing that in the Cobb–Douglas case ln y = ξ ln θ + (1 − ξ ) ln h +
ln l, ξ ∈ (0; 1). If the planner wants to increase h by 1 percent, he can simultaneously increase output by 1 − ξ percent to
hold labor supply constant for any θ . This does not work without the log-separability of θ and h. Then the planner would
need an ability-specific output compensation to hold labor supply constant, which is not feasible for the planner because
ability is not observable.
17
Equation (19) follows replacing τh by b + i on the left hand side of the definition (14), and noticing that
⎡ ⎤
du c
β dc ∂ y ∂ g (h , h ) ⎦ q ∂ y ∂ g (h , h )
b − ∂ g (h ,h)
E⎣ − =− ∂ g (h ,h)
E − .
du (c ) ∂ h ∂ h ∂h ∂h
∂ h dc ∂ h
.
Hence, if labor productivity is not Cobb–Douglas (χ differs from zero), the perturbation described above does not pre-
serve incentive compatibility. For example, if ability and human capital are so complementary that χ < 0, high types are
able to use human capital relatively more efficiently and the indifference curve intersects the perturbed allocation from
above. It is not optimal anymore for the family to keep its labor supply unchanged. Instead, it will reduce its effort and
imitate lower types.18 In other words, increasing human capital makes it more difficult to elicit truthful reporting from
families when χ < 0.
To summarize, i measures the wedge between the first and second-best investment rules due to the impact that
human capital has on the implementability of the allocation. This effect is not internalized by families because they take
the allocation as given. They ignore the impact of their investments on the incentive compatibility of the allocation which
drives a wedge between their optimal choice and that of the planner. Whether this net wedge is positive or negative
depends on the degree of complementarity between human capital and ability.
Discussion. We find that socially optimal distortions of human capital investment are tightly related to the optimal distortions
of bequests. Compared to bequests, human capital carries risk and may change incentives. If χ < 0, human capital worsens
incentives (i > 0) so that the social return on human capital in equation (19) is reduced (vice versa if χ > 0). It follows
that the planner distorts the family’s decision between bequests and human capital investment to equate their social return.
This result is different from Farhi and Werning (2010) because they abstract from risk and do not consider the effect
of human capital on incentives. Findeisen and Sachs (2012, 2016a) take these two channels into consideration and find
that human capital has a negative incentive effect if human capital and innate ability are complements in shifting the
distribution from which next period productivities are drawn. In this case, human capital increases the informational rents
of high-ability types. In our paper, the incentive effect of human capital depends on the degree of complementarity between
human capital and ability in the production function.
Jacobs and Bovenberg (2011) and Stantcheva (2016) also find that human capital leaves the incentive constraint un-
changed solely if the technology of production is Cobb–Douglas. Hence this conclusion holds independently of whether one
considers a life-cycle or an intergenerational problem. There is, however, an important distinction between the two set-ups
as the contemporaneous productivity effect in the life-cycle model of Stantcheva (2016) yields a close relationship between
the wedges for human capital and labor. By contrast, in our intergenerational economy, investment into the human capital
of children increases their productivity in the next period, when these children enter the labor market, so that the human
capital wedge is not anymore closely related to the labor wedge but instead to the wedge for bequests.
Independent and complementary research by Stantcheva (2015) proposes a slightly different interpretation of the dif-
ference between the social return of bequests and human capital, based on proposition 6 in Section 6 of her paper. Her
decomposition emphasizes more the link between human capital and the labor wedge whereas we have stressed the link
to the wedge for bequests.19 Focusing on the link between human capital and bequests seemed natural to us given that the
planner offsets the intratemporal distortions on human capital in the social optimum, as we have explained above.
4. Quantitative analysis
We uncover further interesting features of the optimal allocation by solving the model numerically. We start by explain-
ing how we calibrate the model so that its quantitative implications are comparable to U.S. data.
4.1. Calibration of decentralized economy
In the decentralized economy each family solves the maximization problem20

⎧ ⎫
⎨ ⎬

%
W (b, h, θ, t ) = max U (c , l) + β %
W b , h , θ , t + 1 dF θ |θ
{b ,h ,l,c } ⎩ ⎭

s.t. b = (1 + r )b − T b (b) − c − g (h , h) − T h (h , h) + y − T y ( y ),
b ≥ max{−φ g (h , h), b },
y = Y (h, θ, l).
The borrowing constraint allows families to pass on the fraction φ ∈ (0; 1) of the expenditures for human capital accumu-
lation to the next generation but limits the overall student debt to at most b . Non-linear taxes and subsidies on bequests,
18
The opposite adjustment occurs when χ > 0 as the indifference curve intersects the allocation from below, making it easier to motivate families.
19
As Stantcheva (2015, 2016) points out, it is also worth noting that complementarity between risky ability and human capital investment increases
pre-tax inequality and thus the scope for redistribution and insurance.
20
As in Section 3, the first-order conditions of this problem are equivalent for the problem &
W (b(θ), h(θ), θ, t ) =
$
& + 1 dF θ |θ , s.t. the constraints, which matches the set-up of the planner problem
max{b (θ ),h (θ ),l(θ ),c (θ )} U (c (θ), l(θ)) + β W b (θ), h (θ), θ , t
exactly.
education and labor income are captured by the functions T i (·), for i = b, h, y, respectively. Note that g (h , h) and T h (h , h)
enter additively in the budget constraint. Setting T h (h , h) = 0 allows us to interpret g (h (θ), h) as the net cost of human
capital accumulation.
Utility function. We set the length of a period to 30 years to approximate the time until labor-market entry of a new-born
generation and the length of the labor-market career. For the assumption of an annual discount rate of 3%, this implies
that β = 0.412. We assume q = β to abstract from intergenerational redistribution motives arising from differences in the
planner’s and households’ discount factors (see, for example, Farhi and Werning, 2010). We specify the utility function
as U(c , l) = ln(c ) − lα /α , which satisfies the parametric assumption [A1’] made above. Based on estimates for the Frisch
elasticity of 0.5 documented in Chetty (2012), we obtain that α = ε −1 + 1 = 3.
Production technology. We assume that labor productivity is Cobb–Douglas so that A (θ, h) = θ ξ h1−ξ . The assumption of
Cobb–Douglas productivity has the advantage that, under the assumption of competitive labor markets, wages w (θ, h) are
log-linear in human capital and unobserved ability:
ln w (θ, h) = ln A (θ, h) = (1 − ξ ) ln h + ξ ln θ. (20)

Our model thus predicts that differences in unobserved ability θ generate the residual wage dispersion which remains
in the data after regressing log-wages on years of schooling (where chosen years of schooling S, beyond the compulsory
school years, correspond to ln h in our model). We assume that θ is drawn from a log-normal distribution with a mean
and standard deviation specified in Table 1 that imply a variance of residual wages as estimated by Heathcote et al. (2008,
2010).21 They show that the variance of residual log-wages among U.S. workers due to persistent shocks has been equal
to 0.2 in 2005.22 We use the variance resulting from persistent shocks because θ is fully persistent in our model during a
generation’s labor-market career and transitory shocks (at least partially) wash out.
In order to calibrate the parameter ξ of the production function, we use the large body of empirical evidence on Min-
cerian wage regressions. As surveyed by Card (1999), the literature shows that the marginal returns of an additional year
of schooling are remarkably consistent across studies and close to 10%. Since years of schooling S correspond to ln h in our
model, equation (20) implies that 1 − ξ = 0.1. For agents with compulsory schooling, we set h = 1 so that their chosen years
of schooling are S = ln 1 = 0.
Borrowing opportunities. We allow families to finance up to 50% of their human capital investment with debt of at most
$30,000. That is φ = 0.5 and b = −$30,000. At the time the next generation makes its choices the accrued interest then
implies maximal total debt of $72,818. The implied amount of outstanding student loans thus broadly matches the amounts
reported in Brown et al. (2014).
Approximation of tax schedules. We approximate labor income taxes in the U.S. using the parametrization proposed by
Heathcote et al. (2016) for the U.S.: T y ( y ) = y − δ y 1−t y , with t y = 0.181 and δ = 0.9276.23 Our model does not distin-
guish estates from bequests. We thus approximate taxes on bequests using the parametrization for estate taxes proposed by
De Nardi and Yang (2016) which implies that families pay 20% tax above the exemption of $756,000. Education subsidies
are contained in g (h , h) so that this function captures education costs after subsidies.
Stochastic process for ability and education costs. The remaining parameters for the persistence of ability shocks and the educa-
tion cost function are calibrated jointly to match the following target statistics: the average years of education, the average
net cost of an additional year of secondary/tertiary education, the correlation between years of education across generations
and the intergenerational earnings elasticity.
Although all these parameters are jointly calibrated, we now mention the target moments to which each parameter
is tightly related. The intergenerational earnings elasticity ψ (IGE), resulting from a linear regression of ln y on ln y, is
closely related to the persistence in the stochastic process of ability. This may not be surprising because human capital h
affects labor productivity A (θ, h), and thus labor earnings, much less than ability θ : to keep the model consistent with the
empirical evidence on returns to schooling, the exponent of ability ξ in the Cobb–Douglas function for labor productivity
has to be nine times higher than the exponent of human capital. Hence, the IGE is mostly determined by the persistence
of ability that is fed into the model. The endogenous choices of human capital and labor supply quantitatively matter much
less for labor earnings and thus for the IGE.
21
The log-normal distribution is approximated by a truncated density so that we obtain a compact support. The compact, moving support implies that
we have to adjust the boundary conditions limθ →θ μ (θ) and limθ →θ μ (θ) in the numerical solution, as detailed in the proof of proposition 4 in Farhi and
Werning (2013).
22
See panel C of Figure 3 in Heathcote et al. (2008).
1
23
Observe that T y ( y ) is negative whenever y < δ t y ≈ 2/3. Given that a unit in our model is based on mean earnings of high-school dropouts, as
explained further below, workers whose annual income is below $14,423 receive positive transfers while those above this threshold pay income taxes.
Table 1
Calibrated parameter values.
Parameters Target Source

Preferences
Discount factor: β = q = 0.412 Annualized rate: 3% Standard
Disutility of labour v (l) = lα /α : α=3 Frisch elasticity: 1/2 Chetty (2012)
Production technology: y /l = θ ξ h1−ξ

ξ = 0.9 Returns to education: 10% Card (1999)
Borrowing opportunities
φ = 0.5, b = −$30,000 Student loans in FRBNY Consumer Credit Panel Brown et al. (2014)
Taxes
T y ( y ) = y − δ y 1−
ty
, t y = 0.181, δ = 0.9276 Parametric approximation of the U.S. labor income tax schedule Heathcote et al. (2016)
0.2, if bequest > $756,000
T (b) = tb b, tb =
b
Parametric approximation of the U.S. estate tax schedule De Nardi and Yang (2016)
0, otherwise
' (
σ2 σ2
AR(1)-process for ability: ln(θ ) = ρ ln(θ) + , ln θ ∼ N − 2(1−ρ 2 ) , 1−ρ 2
ρ = 0.459 Intergenerational earnings elasticity: ψ = 0.45 Chetty et al. (2014)
σ2
1−ρ 2
= 0ξ.22 Variance of residual wages: 0.2 Heathcote et al. (2008)
Education cost: g (h , h) = κ ln(h )ς1 ln(h)ς2

κ = 0.001 Average years of schooling: 12.8 Barro and Lee (2013)
ς1 = 4.1657 Average net cost for an additional year of education: $13,845 OECD (2011), Stantcheva (2016)
ς2 = −1.4261 Intergenerational correlation of years of schooling: 0.46 Hertz et al. (2007)
The interpretation of ln h as years of schooling S allows us to use data on average years of schooling and educational
expenditure to determine the parameters κ and ς1 of the cost function g (h , h). Annual expenditure per student and year
in the U.S. amounts to $12,690 for upper-secondary education and to $29,910 for tertiary education (Tables B.1.2 and B.1.6
in OECD, 2011). Hence, the average cost for an additional year of schooling is $21,300. Assuming as in Stantcheva (2016)
that 35% of expenses for human capital investment related to higher education are subsidized, we get the target $13,845
for the cost net of the subsidy. In order to relate the monetary costs observed in the data to units of the model, we make
the empirically plausible assumption that the average worker without any non-compulsory education does not receive, or
leave, any significant bequests, so that she is approximately a hand-to-mouth consumer. Then the income per model period
of such a worker corresponds to 0.9356 in units of the model.24 According to census data, the mean annual earnings of
high-school dropouts have been equal to $20,241 in 2010 with a present value for a 30-year period of $416,974.25 Finally,
the parameter ς2 of the cost function determines how much parental background reduces the cost of education. This allows
the model to match the intergenerational correlation of years of schooling.26
Simulation. We solve the problem by applying the endogenous gridpoint method proposed in Hintermaier and Koeniger
(2010). We describe the algorithm in the online Appendix C and discuss how it handles efficiently the occasionally binding
constraint between the endogenous (state) variables b and h . For the simulations, we draw from the stationary ability
distribution and the empirical joint distribution of wealth and education observed in the SCF 2004. We approximate the
empirical joint distribution by computing average schooling years and net worth in each of the four quartiles of the net-
worth distribution. We further split the top quartile into the top 10% and the lower 15% to better capture the concentration
of net worth at the top of the distribution. We draw 200,000 observations, simulate the respective paths based on the
model solution for a dynasty of four generations (120 years) and focus on the decisions of the second generation when we
compare the model predictions with the data moments.27 Table 2 shows that the calibrated model matches the data targets
quite closely.
24
A hand-to-mouth consumer without bequests consumes net income c = y − T y ( y ) = δ y 1−t y given our assumption that T y ( y ) = y − δ y 1−t y . The
) *
optimal labor supply for a hand-to-mouth consumer without bequests then solves l∗ (θ, h) ≡ arg max ln(δ [ A (θ, h) l]1−t y ) − v (l) . With v (l) = lα /α , we get
1/α 1/α
l∗ (θ, h) = 1 − t y . Since A (1, 1) = 1, the period income of the average worker without any non-compulsory education y ∗ (1, 1) = 1 − t y = 0.9356
when we insert the parameter values documented in Table 1.
25
See Table 232 in the Statistical Abstract of the United States 2012 published by the U.S. Census Bureau. For data sources see https://www.census.gov.
26
When solving the model we add a tiny constant h† = 0.001 to the cost function so that g (h , h) = κ (ln(h + h† ))ς1 (ln(h + h† ))ς2 . This ensures that
the marginal cost is strictly positive and finite at the smallest possible amount of human capital of the current generation h = 1 as well as of the future
generation h = 1.
27
Due to the high discount factor, increasing the horizon of the dynasty has a small effect when T is larger or equal to 3. See Fig. 1 in the online
Appendix D, which illustrates this point for the planner problem.
Table 2
Target statistics in the data and the model.
Variable Data Model

(1) (2)
Average years of schooling S 12.86 12.67
Correlation ( S , S ) 0.46 0.46
Intergenerational earnings elasticity 0.45 0.44
Average net cost of an additional year of schooling $13,845 $14,427
Fig. 2. Investment in children’s human capital as a function of parental income, for different persistence of ability across generations. Notes: We condition
on parents with zero assets and 12 years of schooling. In the case with persistent ability with persistence parameter ρ = 0.459 as in Table 1, we set ability
of the past generation θ0 = 1, so that ability draws for the current generation are comparable to the case with uncorrelated abilities.
4.2. Optimal allocation
We now describe the optimal allocation resulting from our calibrated parameters. In the illustrations below, we focus
on dynasties whose first generations are high-school graduates (the chosen years of schooling beyond compulsory schooling
S = 4) and normalize their parents’ productivity θ0 to one. Then we choose the initial promised value which ensures that
the planner breaks even.28
Human capital investment and parental income. Fig. 2 shows that the persistence of ability across generations determines
whether optimal investment into education decreases or increases in parental income, and thus parents’ ability. To provide
intuition for this result, let us first comment on the case with uncorrelated ability.
If abilities were observable and uncorrelated across generations, the first best allocation would provide all children with
the same level of education. Under asymmetric information instead, the planner’s insurance of the current generation is con-
strained by incentive compatibility. This requires that the planner promises additional utility to families with currently high
ability. The planner achieves this goal by giving children of talented parents more consumption and by letting them produce
less output, thereby reducing their disutility of labor. In the decentralized allocation, children inherit higher bequests when
the productivity of their parents is high, which entails a negative wealth effect on their labor supply.
The smaller labor effort of children of high-ability parents makes it, in turn, less attractive for the planner to invest
into their human capital. This is why, for the case of uncorrelated abilities in Fig. 2,29 children of very able parents only
receive 12.2 years of education, roughly corresponding to high-school graduation, whereas hard-working children of low-
ability parents complete almost 1 more year of education. Optimal education hence exerts a mean-reverting influence across
generations by ensuring that labor market productivity of parents and expected labor market productivity of their offspring
are negatively correlated.
Fig. 2 also shows how positively correlated abilities across generations introduce an additional effect that changes the
slope of optimal human capital investment. When ability is persistent, high-income parents are expected to have more
28
The algorithm for solving the planner problem is discussed further in the online Appendix D. Since it relies on the recursive formulation outlined in
Appendix A, we also have to initialize the state variable defined in (A.3). Given that can be freely chosen in the first period, we set it so as to minimize
costs, i.e., 1 ∈ arg min ( V 1 , , h1 , θ0 , 1).

29
The allocation with uncorrelated types is based on the parameters in Table 1 with the exception of ρ which we set equal to 0.
Fig. 3. Human capital accumulation as a function of families’ inherited wealth and annual labor income when ability is persistent. Notes: see Figure 2.
able children. This makes it beneficial for the planner to endow these children with more human capital. For the calibrated
correlation of ability ρ = 0.459, this ability transmission channel dominates the wealth effect described above, so that optimal
human capital investment now increases in the income of parents.
Quantitatively, the effect of parental income on optimal education with persistent ability is positive but rather small.
In the illustration of Fig. 2, doubling parental income from $15,000 to $30,000 increases optimal education by about half
a year. In the calibrated economy, in which we approximate the observed tax schedules for the U.S., the effect of such a
doubling of parental income on education has the same magnitude. This modest impact is in line with empirical evidence
on parental income and college enrollment by Hilger (2016) as well as the findings in Findeisen and Sachs (2016b).
Education and family background. The model also allows us to illustrate the influence that inherited wealth has on optimal
education.30 Contrasting the impact of bequests with that of labor income is of particular interest because it allows us to
isolate the wealth effect on optimal human capital accumulation. Fig. 3 highlights that parents’ wealth and labor income
have qualitatively different effects on the optimal level of education if ability is persistent.31 This is intuitive because income
is correlated with current ability whereas inherited wealth is not.32 As explained above, the wealth effect lowers the labor
effort of the offspring, making it less attractive for the planner to invest in their education. By contrast, higher labor income
is correlated with current ability and, since ability is persistent, it raises expectations about children’s abilities, making it
more attractive for the planner to invest into their human capital.
Empirical evidence by Holtz-Eakin et al. (1993) and Brown et al. (2010) shows that a negative wealth effect of inheritance
on labor supply is plausible. This wealth effect is often used in the public debate to advocate higher taxes on inherited
wealth so that the currently young generation maintains a high labor effort. The insight from our dynamic intergenerational
model is that such proposals should be treated with caution: the incentive scheme in the constrained-efficient allocation
exploits that bequests increase children’s consumption and lower their labor effort. This allows the planner to redistribute
resources in the current generation while ensuring incentive compatibility.
Finally, family background affects human capital investment in our model also because of differences in parents’ edu-
cation. The correlation is positive because the calibrated cost function g (h , h) implies that better educated parents have a
cost advantage when investing into the education of their offspring (see Table 1). This effect is rather mechanical, so that
we do not elaborate further on it.
The human capital wedge. Fig. 4 illustrates the tight relation between the wedges for bequests and human capital.33 As is
to be expected from results on wedges for savings in Kocherlakota (2010), chapters 3 and 4, the wedge for bequests is
regressive: it is decreasing in income because the planner wants to discourage families with bequests to shirk and report a
low type. It follows from Proposition 2 that the wedge for human capital in the calibrated Cobb–Douglas case reads
30
We vary the promised value V which corresponds to varying assets of families in the decentralized allocation. To simplify the interpretation of the
figures, we replace the promised values by the corresponding levels of bequest, b( V , , θ, h, t ) = ( V , , θ, h, t ), in the decentralized allocation.
31
If ability is uncorrelated instead, the effect of income and inherited wealth on optimal education is similar. See the working paper version in CEPR
Discussion Paper 10267.
32
Remember that Fig. 3 is conditional on ability in the previous generation being normalized to one, i.e., θt −1 = 1.
33
The labor wedge implied by the model is standard so that we delegate the illustration of it to the online Appendix D. There we also illustrate the size
of the distortion of the labor wedge on human capital investment and show that it is offset by the incentive effect because our illustration assumes that
technology is Cobb–Douglas.
Fig. 4. Wedges for human capital and bequests as a function of labor income. Notes: Calibrated model with persistent abilities, see Figure 2 for more details.

∗ τ∗ β du c ∂ y ∂ g (h , h )
τh = b ∗ + ∂ g (h ,h) du (c )
Cov , − . (21)
1 − τb dc ∂h ∂ h
∂ h dc
It differs from the wedge for bequests because human capital carries risk. Since τh∗ < τb∗ /(1 − τb∗ ) in Fig. 4, the covariance
term in equation (21) is negative, showing that human capital provides a bad hedge against consumption risk.
The planner does not have to discourage human capital accumulation as much as bequests because parents cannot
diversify the risk associated with their children’s ability. This explains why the implicit tax on bequests τb∗ is always positive
whereas the implicit tax on human capital τh∗ is negative, implying that human capital should be subsidized.
Moreover, further results (not reported in this paper for brevity) show that the effect of income on the gap between
the two wedges is ambiguous. There are at least two forces at work. On the one hand, the offspring will enjoy higher
consumption on average if labor income is higher. This lowers the absolute value of the covariance term in (21) if u (c ) < 0,
as is the case for log utility in our numerical solution, so that marginal utility is decreasing at a decreasing rate. Then similar
changes in consumption will generate smaller fluctuations of marginal utility at higher consumption levels. This effect may
dominate the regressivity induced by the wedge for bequests τb∗ , implying an implicit tax on human capital that is locally
flat or even progressive.34 On the other hand, persistence of ability implies that the risk of human capital investment
changes with current ability and thus income, hence affecting the gap between the two wedges.
Correlations across generations. Fig. 5 plots simulated values of labour income and chosen years of schooling in the second
generation against their values in the first generation. The figure shows that both variables are positively correlated from one
generation to the next. The linear-regression coefficients for income of 0.4 remains close to the one for ability ρ = 0.459.
This confirms our finding for the calibrated economy that, given the much greater weight assigned to ability in the marginal
product of labor A (θ, h), observed education choices only have a second-order effect on intergenerational inequality.35
Complementarity and incentive wedge. The numerical results are based on the canonical Mincerian specification of the wage
equation for which wages are log-linear in schooling, with a constant slope across ability groups. Changing the parameter
χ which controls the degree of complementarity between θ and h allows us to check the importance of the Cobb–Douglas
assumption. As shown in Proposition 2, χ
= 0 introduces an additional motive for the planner to tax or subsidize human
capital investment. The results presented in the online Appendix D show that the shape of the human capital wedge remains
very similar but its level is shifted by the incentive effect i .
34
See the working paper version (CEPR Discussion Paper 10267) for an illustration of this effect with uncorrelated abilities.
35
For a tighter comparison with the calibrated economy, we simulate the calibrated economy using the same initial conditions of 12 years of schooling
and zero wealth as in Fig. 5. This simulation confirms the very similar correlations of income across generations in the calibrated economy and in the
planner problem.
Fig. 5. Scatter plots of labor income and schooling years. Notes: see Fig. 2.
5. Implementation
The social optimum can be decentralized through a general schedule T t (bt , yt , ht +1 , θ t −1 ) for taxes and transfers that
condition on the history of types θ t −1 and punish choices off the equilibrium path.36 Each family solves the following
problem37
T

s−t s s
max Et β U c s (θ ), l s (θ )
bt +1 (θ t ),ht +1 (θ t ),lt (θ t ),ct (θ t ) θ t
s=t
s.t. bt +1 (θ t ) = (1 + r )bt − ct (θ t ) − g (ht +1 (θ t ), ht ) − T t (bt , yt (θ t ), ht +1 (θ t ), θ t −1 ),

yt (θ t ) = Y (ht , θt , lt (θ t )).
Below we will see that the history dependence of the schedule T t (·) can be achieved by conditioning on past income and
education loans. Before elaborating on such a specific implementation, it is insightful to relate the marginal taxes resulting
from the optimal tax schedule T t (·) to the wedges which we have derived earlier.
Marginal taxes and wedges. The first-order condition for labor supply and the definition of the labor wedge (13) imply that the
marginal income tax equals the labor wedge: ∂ T t (·)/∂ yt = τl,t (·), where the notation τl,t (·) shall make explicit, compared
to our shorthand notation introduced before, that the labor wedge depends on the same variables as the tax schedule.
Concerning τb,t (·), the first-order condition with respect to bt +1 implies that

du ct (θ t ) ∂ T t +1 (·) du ct +1 (θ t +1 )
= βEt 1+r − .
dct ∂ b t +1 dct +1
The wedge for bequests τb,t (·) generally has to be implemented by taxes that ensure that it also holds ex post, thus ensuring
that the Euler equation of families is satisfied for each consumption level at the reported ability (Kocherlakota, 2010).
Otherwise some families would find it optimal to deviate from the social optimum by bequeathing and letting their children
exert little labor effort.
To see how the marginal tax on human capital investment is related to the wedge τh,t (·), we combine the first-order
condition for human capital and the definition of the wedge for human capital (14):
⎡
du ct +1 (θ t +1 )
⎤

∂ T t (·) ∂ g (ht +1 , ht ) ∂ yt +1 ∂ T t +1 (·) ∂ T t +1 (·)
τh,t (·) − βEt ⎣ ⎦.
dct +1
= + (22)
∂ h t +1 ∂ h t +1 ∂ h t +1 ∂ y t +1 ∂ h t +1 du ct (θ t )
dct
36
For an application in a life-cycle model with human capital, see Stantcheva (2016) who builds on Farhi and Werning (2013) and Albanesi and Sleet
(2006).
37
Note that there is no borrowing constraint in this problem because the schedule that implements the social optimum ensures that such a constraint is
never binding.
A positive wedge for human capital does not necessarily imply a positive current marginal tax on human capital accumula-
tion in a dynamic model. The second term on the right-hand side shows that the latter also depends on how human capital
changes taxes in the next period and how these changes are correlated with the marginal utility of consumption.38
Equation (22) allows us to relate our results to the recommendation by Bovenberg and Jacobs (2005) according to which
education expenses should be fully tax deductible to avoid distorting human capital investment. We recover the analogon
of this result in our model: if, as in Bovenberg and Jacobs (2005), there are no bequests and productivity is Cobb–Douglas
(χ = 0), τh,t (·) = 0 and human capital accumulation is socially optimal in the laissez faire without tax distortions. Then
equation (22) reads
⎡ du c (θ t +1 ) ⎤
t +1
∂ T t (·) ∂ yt +1 ∂ T t +1 (·) ∂ T t +1 (·)
Et ⎣ ⎦
dct +1
= −βEt +
∂ h t +1 ∂ h t +1 ∂ y t +1 ∂ h t +1 du ct (θ t )
dct

β ∂ yt +1 ∂ T t +1 (·) ∂ T t +1 (·) du ct +1 (θ t +1 )
− t Covt + , .
du ct (θ ) ∂ h t +1 ∂ y t +1 ∂ h t +1 dct +1
dct
The current marginal tax on human capital accumulation ∂ T t (·)/∂ ht +1 is negatively related to the expected change in the
risk-adjusted return to human capital for the next generation caused
by the change in taxes. This expected change consists of
∂y ∂T (·) ∂T (·)
two terms. The first term is the expected change in taxes Et ∂ h t +1 ∂ ty+1 + ∂ ht +1 resulting from an additional marginal
t +1 t +1 t +1
unit of human capital. Compared with Bovenberg and Jacobs (2005), this tax change does not only consist of the additional
marginal income tax but also of the change in taxes due to the higher human capital stock of the next generation. The
second term captures that the returns to human capital are uncertain so that it matters whether the tax changes reduce
consumption risk.39 Hence, education should be subsidized if human capital investment increases the tax burden, and the
future tax changes caused by human capital accumulation do not reduce consumption risk too much.
This is not the whole story in our model, however, since the intertemporal dimension with bequests and a labor pro-
ductivity that is not Cobb–Douglas imply that τh∗,t = b + i
= 0 at the social optimum (see Proposition 2). Hence, optimal
taxes or subsidies do not only try to offset how human capital alters future tax payments but also account for (i) the dis-
tortions at the intertemporal margin relative to bequests (captured by b ), and (ii) the distortions due to changes in the
power of incentives (captured by i ).
An implementation with contingent repayments of loans. Among the many ways to decentralize the social optimum, we focus
on an implementation scheme that builds on the actual tax system. Assuming that taxes can only condition on contem-
poraneous labor income, we use education loans with history-dependent repayments to implement the planner’s solution.
y 1−t y
Specifically, we assume that T t ( yt ) = yt − δ yt with values for t y and δ as specified in Table 1. We then introduce a loan
scheme through which families finance education expenditures so that L t (ht +1 , ht ) = g (ht +1 , ht ).40 The consolidated repay-
ment D t (bt , yt , ht +1 , L t −1 , yt −1 ), which we also call net payment, depends on the amount of accumulated human capital
ht +1 and is means-tested by conditioning on financial resources bt and labour income yt .41 The consolidated repayment
does include not only the repayment of the education loan of the parents but also any residual payments that are not
covered by the income tax. Hence, the decomposition of the gross payment T t (·) in this implementation is as follows:
= T t ( yt ) − Lt (ht +1 , ht ) + D t (bt , yt , ht +1 , Lt −1 , yt −1 ),
y
T t (·)
+,-. + ,- . + ,- . + ,- .
Gross payment Income tax Education loan Net payment
so that, substituting in our assumptions for the tax schedules of income, the budget constraint reads
bt +1 (θ t ) = (1 + r )bt − ct (θ t ) − g (ht +1 (θ t ), ht ) + δ yt 1−t y + L t (ht +1 , ht ) − D t (bt , yt , ht +1 , L t −1 , yt −1 ).
38
Note that if the conditioning on the history of past types θ t −1 is implemented by conditioning on the history of human capital accumulation and
output (as in our illustration with loans and contingent repayments below), there are additional terms in the above equation that capture how the future
schedules T t +2 (·), T t +3 (·), ..., are affected by a change of ht +1 . For simplicity, we abstract from these additional terms in our discussion.
39
The covariance term relates to Eaton and Rosen (1980) who show that, under certain conditions, labor income taxes may foster human capital in-
vestment by reducing risk. The covariance term in the equation shows that, in this case, less education subsidies are needed to encourage human capital
investment.
40
Compared to the model which we calibrated for the U.S., this implies that agents can borrow more than the fraction φ ∈ (0; 1) of education expendi-
tures.
41
With persistent ability shocks we have to condition on the history of types θ t −1 . This is achieved by the conditioning on the history of loans and
income if a history of yt −1 and ht −1 determines a unique θ t −1 , as in Stantcheva (2016). Note that the history of human capital is contained in L t −1 .
If ability is i.i.d. across generations, the history can be summarized by two state variables: bequests and human capital (see the working paper version
in CEPR Discussion Paper 10267). In this case, the constrained-efficient allocation can be implemented either with means-tested grants that depend on labor
income y, human capital h and condition on the state variables b and h; or with loans for human capital accumulation featuring repayment schedules
that depend on y, h , condition on b and h and are complemented with labor income taxes that only depend on current income.
Fig. 6. Implementation of the social optimum with loans and contingent payments. Notes: see Fig. 2.
Fig. 7. Net payments as a function of annual labor income and bequests. Notes: see Fig. 2.
Existing tax and subsidy systems for student loans in continental Europe and Anglo-Saxon countries contain elements
which resemble this implementation scheme. The conditioning on bequests and human capital roughly corresponds to re-
payment schedules for student loans that condition on parents’ permanent income (which is highly correlated with human
capital) and parents’ wealth (which is correlated with bequests). We now illustrate the implementation for the first genera-
tion, for which no further conditioning is required.42
Figs. 6 and 7 show how the social optimum can be implemented by optimal design of education finances alone, taking
the existing income tax schedule in the U.S. as given. This may be of interest if reforming the whole tax system is politically
infeasible but a separate reform of education finances is possible.
Fig. 6 illustrates how the implementation scheme depends on labor income for our representative family with no assets
and parents with a high-school degree. Its upper-panel shows that education loans increase in income because years of
schooling are also increasing in income in the social optimum (see Fig. 2). Given the progressive U.S. income tax schedule,
the net payment has to balance insurance and incentives to implement the gross payment required in the social optimum.
Since the income tax is convex in income, the lower panel of Fig. 6 shows that the schedule for the net payment becomes
slightly regressive for families with a labor income above $60,000. This prediction is in line with the finding in Heathcote et
al. (2016) that the value of progressivity of the income tax that maximizes social welfare is lower than the one observed in
the data. Although the net payment compensates some of the progressivity of observed income taxes, it provides substantial
insurance: low-income families do not have to repay the education loans of the parents and benefit from net transfers, while
receiving loans for the education of their children.
42
Assessing the welfare gains of history-dependent tax schedules compared to optimal restricted tax schedules, without history dependence, is beyond
the scope of this paper.
This is illustrated further in Fig. 7 which plots the net payment D (·) as a function of income and wealth. The figure
shows that the net repayment increases in wealth for most families although optimal education, and thus the associated
financing loans L t (·), decrease in wealth (see Fig. 3). Income-poor families are recipients of net education subsidies whose
size decreases more rapidly in income if they have less inherited wealth. Intuitively, the repayment schedule is more pro-
gressive for families with little wealth and less elastic labor supply.
6. Conclusion
We have shown that human capital investment by families is not constrained efficient if the ability of generations in a
family dynasty is not observable. The wedge for human capital differs from the wedge for bequests at the social optimum
because human capital carries more risk, as parents cannot diversify the uncertainty associated with their children’s ability,
and because human capital may change incentives. We find that the planner should pay attention to whether consumption
is financed through labor income or inherited assets, and subsidize the education of children whose parents earn a higher
share of their income through their effort on the labor market. This recommendation can be implemented by loans with
contingent repayments that are on average less costly, but also more progressive, for children from a poorer family back-
ground. A promising avenue for further research would be to investigate the extent to which the second-best allocation can
be approximated by less sophisticated implementation schemes that do not rely on history dependence.
Our quantitative results imply that the empirically observed intergenerational earnings elasticity of 0.45 is (close to)
socially optimal. We obtain this result in our model because of the tight relationship between exogenous unobservable ability
and labor income productivity, as implied by the relatively small estimates of around 10% for the effect of an additional
observable year of schooling on labor productivity. Future studies should strive to evaluate the robustness of this result in
more general settings where parents are also able to invest into the unobserved ability of their children.
Appendix A. Analysis of the planner problem and proofs
A recursive representation
of the
$ relaxed
problem (8) can be derived as follows. First define the promised value at the
end of period t − 1 as V θ t −1 ≡ ω θ t dF ( θt | θt −1 ). The continuation values are by definition equal to

ω θ t = U ct θ t , yt θ t , ht θ t −1 , θt + β V θ t .

Taking the promised value V θ t −1 as given and using the simpler notation V , we can rewrite (8) in recursive form:
( V , , h, θ− , t )
⎧ ⎫
⎨ ⎬
= min c (θ) + g (h (θ), h) − y (θ) + q V (θ) , (θ) , h (θ), θ, t + 1 dF ( θ| θ− ) ,
{c , y ,h , , V } ⎩ ⎭

subject to
ω (θ) = U (c (θ) , y (θ) , h, θ) + β V (θ) , (A.1)

V = ω (θ) dF ( θ| θ− ) , (A.2)

∂ f ( θ| θ− )
= ω (θ) dθ, (A.3)
∂θ−

∂ ω (θ) ∂ U (c , y , h, θ)
= + β (θ) , (A.4)
∂θ ∂θ
where we only keep a time index for the value function, and otherwise use a prime “ ” to denote next period realizations
and an underscore “_” to denote a realization in the last period. Note that we have inverted the human capital accumulation
function h (e , h) to substitute e (θ) with g (h (θ), h). Equation (A.3) defines the additional state variable . It is sometimes
referred to as the threat-keeping constraint (Fernandes and Phelan, 2000) because the planner keeps track of how reports
of ability in the last period change promised utility. Substituting this equation into condition (7), we write the envelope
condition in the recursive form displayed in (A.4). With correlated types, we also need to condition on last generation’s
type θ− because it affects the distribution F from which current types are drawn.
Following Mirrlees’ (1971) approach, we solve for using standard optimal control techniques. First we use (A.1) to re-
place consumption with c ω (θ) − β V (θ) , y (θ) , h, θ . Then we treat ω (θ) as the state variable obeying the law of motion
given by the envelope condition (A.4) with costate variable μ(θ). Associating the multiplier λ and γ with the promise-
keeping constraint (A.2) and threat-keeping constraint (A.3), the Hamiltonian reads

H = c ω (θ) − β V (θ) , y (θ) , h, θ + g (h (θ), h) − y (θ)

+ q V (θ) , (θ), h (θ), θ, t + 1 f ( θ| θ− )

∂ f ( θ| θ− )
+ λ [V − ω (θ) f ( θ| θ− )] + γ − ω (θ)
∂θ−

∂ U c ω (θ) − β V (θ) , y (θ) , h, θ , y (θ) , h, θ
+ μ (θ) + β (θ) .
∂θ
The first-order conditions are

∂ V (θ) , (θ) , h (θ) , θ, t + 1 ∂ c (θ) μ (θ) ∂ 2 U (·) ∂ c (θ)
q =− − , (A.5)
∂ V (θ)
∂ V (θ) f ( θ| θ− ) ∂θ∂ c (θ) ∂ V (θ)

∂ V (θ) , (θ) , h (θ) , θ, t + 1 μ (θ)
q = −β , (A.6)
∂ (θ) f ( θ| θ− )

∂ V (θ) , (θ) , h (θ) , θ, t + 1 ∂ g (h (θ), h)
q =− , (A.7)
∂ h (θ) ∂ h (θ)
2
∂ U (·) ∂ c (θ) ∂ 2 U (·) ∂ l (θ) ∂ c (θ) f ( θ| θ− )
+ =− −1 , (A.8)
∂θ∂ c (θ) ∂ y (θ) ∂θ∂ l (θ) ∂ y (θ) ∂ y (θ) μ (θ)
while the costate variable obeys the law of motion

∂ μ (θ) ∂ c (θ) ∂ f ( θ| θ− )/∂θ− μ (θ) ∂ 2 U (·) ∂ c (θ)
=− −λ−γ + f ( θ| θ− ), (A.9)
∂θ ∂ ω (θ) f ( θ| θ− ) f ( θ| θ− ) ∂θ∂ c (θ) ∂ ω (θ)
with the usual boundary conditions limθ→θ μ (θ) = 0 and limθ→θ μ (θ) = 0. We use assumption [A1] to invert the utility
function

c ω (θ) − β V (θ) , y (θ) , h, θ = u −1 ω (θ) − β V (θ) + v ( y (θ) , h, θ) .
It follows that
∂ c (θ) 1 ∂ c (θ) β
= , =− ,
∂ ω (θ) du (c (θ)) /dc (θ) ∂ V (θ) du (c (θ)) /dc (θ)
∂ c (θ) ∂ v ( y (θ) , h, θ)/∂ y (θ) ∂ c (θ) ∂ v ( y (θ) , h, θ)/∂ h
= , = .
∂ y (θ) du (c (θ)) /dc (θ) ∂h du (c (θ)) /dc (θ)
Condition for V : Since [A1] implies ∂ 2 U (·) /(∂θ∂ c ) = 0, equation (A.5) simplifies to

1 q ∂ V (θ) , (θ) , h (θ) , θ, t + 1 q
= = λ (θ) , (A.10)
du (c (θ)) /dc (θ) β ∂ V (θ) β
where we have used the envelope condition ∂ ( V , , h, θ− , t ) /∂ V = λ.
∂ y ∂ 2 v ( y ,h,θ)
Condition for y: Using ∂ 2 U (·) /(∂θ∂ l) = − ∂ l ∂θ∂ y in (A.8) yields
∂ v ( y (θ) , h, θ)/∂ y (θ) μ (θ) ∂ 2 v ( y (θ) , h, θ)

1− =− . (A.11)
du (c (θ)) /dc (θ) f ( θ| θ− ) ∂θ∂ y (θ)
Condition for h : The following envelope condition for human capital is obtained after substituting consumption us-
ing the promise-keeping constraint, noting that there is a continuum of incentive constraints and that [A1] implies
∂ 2 U (·) / (∂ c ∂θ) = 0

∂ ( V , , h, θ− , t ) ∂ c (θ) ∂ g (h (θ), h) ∂ 2 U (·)
= + dF ( θ| θ− ) + μ(θ) dθ
∂h ∂h ∂h ∂θ∂ h

∂ v ( y (θ) , h, θ)/∂ h ∂ g (h (θ), h) ∂ 2 v ( y , h, θ)
= + dF ( θ| θ− ) − μ(θ) dθ .
du (c (θ)) /dc (θ) ∂h ∂θ∂ h

The last term captures the effect of human capital on the incentive compatibility constraint. Note further that for deriving
the envelope condition we have inverted h (e , h) and substituted in e = g (h , h), and we have used that (A.7) and (A.8) hold
for all θ . The envelope condition for human capital can then be inserted into the optimality condition for human capital
(A.7) to obtain

∂ g (h (θ), h) ∂ v y (θ ), θ , h /∂ h ∂ g (h (θ ), h )
= −q + dF ( θ θ)
∂ h (θ)
du (c (θ )) /dc (θ ) ∂h

∂ 2 v ( y (θ ), θ , h )
+q μ (θ ) dθ . (A.12)
∂θ ∂ h

For ∂ 2 U (·) / (∂ c (θ) ∂θ) = 0, equation (A.9) implies
θ
1 ∂ f ( x| θ− )/∂θ−
μ (θ) = − +λ+γ dF ( x| θ− ). (A.13)
du (c (x)) /dc (x) f ( x| θ− )
θ
Proof of Remark 1. Evaluating the law of motion (A.13) of the costate variable at the upper bound of the ability distribution
yields
θ
∂ c (θ)
λ− dF ( θ| θ− ) = μ θ = 0, (A.14)
∂ ω (θ)
θ
where we use that

⎡ ⎤

∂ f ( θ θ ) ∂ f ( θ θ )
∂ f ( θ θ)
E⎣ ∂θ ⎦= ∂θ
f ( θ θ)dθ = d θ = 0.
f ( θ | θ)
f ( θ | θ) ∂θ

The last equality follows because the changes ∂ f ( θ θ)/∂θ in the density have to sum to zero across all θ . Using

∂ c (θ) /∂ ω (θ) = [du (c (θ)) /dc (θ)]−1 and leading this equation one period ahead, we find that λ (θ) = E du c (θ ) /
−1
dc (θ ) . Combining this equality with (A.10), we finally obtain the reciprocal Euler equation. 2
Proof of Proposition 1. The proposition summarizes equations (A.12), (A.13), and (A.14) derived above. 2
Remark 4. Under assumptions [A1’] and [A2]:
∂ v ( y , h, θ) ∂ v ( y , h, θ) ∂ v ( y , h, θ)
< 0, < 0, > 0,
∂h ∂θ ∂y
∂ v ( y , h, θ) ∂ v ( y , h, θ)
≥ 0 iff χ ≥ −α , < 0.
∂θ∂ h ∂θ∂ y
Proof. Inverting the production function y = Y (h, l, θ) = A (θ, h) l, we get l = y / A (θ, h) with A (θ, h) = [ξ θ χ + (1 − ξ ) hχ ]1/χ
so that
' (
y
∂ v ( y , h, θ) ∂ v A (θ,h) ∂ v (l) 1
= = > 0,
∂y ∂y ∂l A
' (
y
∂ v ( y , h, θ) ∂ v A (θ,h) ∂ v (l) y ∂ A (θ, h) ∂ v (l)
= =− 2
=− l (1 − ξ ) hχ −1 A −χ < 0,
∂h ' ∂ h
( ∂ l A ∂ h ∂ l
y
∂ v ( y , h, θ) ∂ v A (θ,h) ∂ v (l) y ∂ A (θ, h) ∂ v (l) χ −1 −χ
= =− 2
=− lξ θ A < 0.
∂θ ∂θ ∂l A ∂θ ∂l
Differentiating these expressions a second time, we get
' (
y
2
∂ v ( y , h, θ) ∂ 2v A (θ,h)∂ 2 v (l) y ∂ A (θ, h) ∂ v (l) 1 ∂ A (θ, h)
= =− −
∂θ∂ y ∂θ∂ y ∂ l2 A 3 ∂θ ∂l A2 ∂θ
∂ A (θ,h) 2 2 χ − 1
∂ v (l) l∂ v (l) /∂ l ξθ ∂ v (l)
= − ∂θ 2 1+ = − 1 +χ α < 0,
A (θ, h) ∂l ∂ v (l) /∂ l A ∂l
and
∂ 2 v ( y , h, θ) ∂ 2 v (l) ' y (2 ∂ A (θ, h) ∂ A (θ, h)

=
∂θ∂ h ∂ l2 A2 ∂θ ∂h
∂ v (l) 2 y ∂ A (θ, h) ∂ A (θ, h) ∂ v (l) y ∂ 2 A (θ, h)
+ −
∂l A3 ∂θ ∂h ⎛ ∂l A
2 ∂θ∂ h ⎞
⎜ ∂ 2 A (θ,h) ⎟
∂ v (l) y ∂ A (θ, h) ∂ A (θ, h) ⎜ 2 2
⎜1 + l∂ v (l) /∂ l + 1 − ∂θ ∂ h
A (θ, h) ⎟
⎟.
= ⎜ ∂ A (θ,h) ∂ A (θ,h) ⎟
∂l A3 ∂θ ∂h ⎝ ∂ v (l) /∂ l ⎠
+ ,- . + ∂θ
,- ∂h
.
ε vl ρhθ
Under assumptions [A1’] and [A2], ε vl = α − 1 and ρhθ = 1 − χ so that

∂ 2 v ( y , h, θ) ∂ v (l) y ξ θ χ −1 (1 − ξ ) hχ −1
= (α + χ ) .
∂θ∂ h ∂l A Aχ Aχ
Then, ∂ 2 v ( y , h, θ)/ (∂θ∂ h) ≥ 0 iff χ ≥ −α . 2
Proof of Corollary 1. Follows immediately from Remark 4 above. 2
Proof of Remark 2. Bequests. The first-order condition for bequests reads

∂ U (c , l) ∂ W b , h , t + 1
− +β = 0,
∂c ∂ b
which, reinserting the envelope condition
∂ W (b, h, t ) ∂ U (c , l)
= (1 + r ) ,
∂b ∂c
yields the Euler equation

∂ U (c , l) ∂ U c , l ∂ U c , l
= β(1 + r ) dF θ θ = β(1 + r )E .
∂c ∂ c ∂ c

Labor supply. The first-order condition for labor supply reads

∂ U (c , l) ∂ W b , h , t + 1 ∂ y
+β = 0.
∂l ∂ b ∂l
The results above imply

∂ W b , h , t + 1 ∂ y ∂ U (c , l) ∂ y
β = ,
∂ b ∂l ∂c ∂l
so that the first-order condition for labour supply simplifies to the standard intratemporal condition
∂ U (c , l) ∂ y ∂ U (c , l)
+ = 0.
∂l ∂l ∂c
Human capital. The first-order condition for human capital accumulation is

∂ g (h , h) ∂ U (c , l) ∂ W b , h , t + 1
− +β = 0.
∂ h ∂c ∂ h
Using the envelope condition

∂ W b , h , t + 1 ∂ U c , l ∂ y ∂ g (h , h )
= − dF θ θ ,
∂ h ∂ c ∂ h ∂ h

then implies that the first-order condition for human capital simplifies to

∂ g (h , h) ∂ U (c , l) ∂ U c , l ∂ y ∂ g (h , h )
=β − dF θ θ . 2
∂ h ∂c ∂c ∂h ∂h

Proof of Remark 3. The wedge τl evaluated at the solution of the planner’s problem follows immediately by using the
definition for τl in the first-order
condition (A.11) of the planner. To derive the analogous expression for τb , we recall that
λ (θ) = E 1
du (c (θ ))/dc (θ )
and rearrange the definition of τb to substitute du (c ) /dc in condition (A.10). 2
Corollary 2. Under assumption [A1’] and [A2]
θ
τl ξ θ χ du (c ) /dc ∂ f ( x| θ− )/∂θ− 1
=α χ λ+γ − f ( x| θ− )dx,
1 − τl A θ f ( θ| θ− ) f ( x| θ− ) du (c (x)) /dc (x)
θ
where α = ε −1 + 1 and ε denotes the Frisch elasticity of labor supply.
Proof of Corollary 2. To compare the labor wedge in our model with the literature, we use definition (13) to derive
∂ v ( y ,h,θ )/∂ y
τl 1− du (c )/dc du (c ) /dc
= = τl .
1 − τl ∂ v ( y ,h,θ )/∂ y ∂ v ( y , h, θ)/∂ y
du (c )/dc
Thus, (16) implies that at the solution of the planner’s problem,
τl du (c ) /dc ∂ 2 v ( yh, θ) μ (θ)

=− .
1 − τl ∂ v ( y , h, θ)/∂ y ∂θ∂ y f ( θ | θ)
By Remark 4,
τl du (c ) /dc ξ θ χ −1 ∂ v (l) μ (θ)

= α
1 − τl ∂ v(l) 1 A 1 +χ ∂l f ( θ | θ)
∂l A
θ
ξ θ χ du (c ) /dc ∂ f ( x| θ− )/∂θ− 1
=α χ λ+γ − dF ( x| θ− ),
A θ f ( θ | θ) f ( x| θ− ) du (c (x)) /dc (x)
θ
where we have substituted in μ(θ) using (A.13). 2
Let us briefly comment on the labor wedge. To compare this wedge with results in Mirrlees (1971), set γ = 0 and note
that the multiplier λ is in the numerator since the shadow price λ is in units of marginal utils and not of public funds of
the planner. Furthermore, limθ→θ μ (θ) = 0 and limθ→θ μ (θ) = 0 imply that
θ θ
1 1
λ− ∂ u (c (x))
dF (x) = ∂ u (c (x))
− λ dF (x).
θ ∂ c (x) θ ∂ c (x)
With persistent ability, the equation for the labor wedge in Corollary 2 is analogous to the equation following (A.7) in the
proof of proposition 2 in Farhi and Werning (2013), p. 630.
Proof of Proposition 2. The wedge for human capital implied by the solution to the planner’s problem is obtained adding
τh on both sides of condition (A.12), and substituting its definition on the right-hand side to get
⎡ ⎤
du c
β ∂
dc y ∂ g (h , h )
τh = ⎣ − ⎦ dF ( θ θ) − 1
∂ g (h ,h) du (c )
∂h ∂h
∂ h dc
⎛ ⎞
∂ v y ,θ ,h
q ∂ g (h , h )
− ⎝− ∂h
− ⎠ dF ( θ θ) + 1
∂ g (h ,h) du (c ) ∂ h
∂ h dc

q ∂ 2
v ( y , θ , h )
− ∂ g (h ,h)
μ θ dθ .
∂θ ∂ h
∂ h

∂ v y ,θ ,h ∂ v ( y ,θ ,h )
Since the derivatives of the multivariate function v ( y , h, θ) in the proof of Remark 4 imply that ∂ h = − ∂∂ hy ∂ y ,
this can be rearranged as
⎛ ⎞
∂ v ( y ,θ ,h )
q ∂ y ⎝ ∂ y
τh = 1− ⎠ dF ( θ θ)
∂ g (h ,h) ∂ h du (c )
∂ h dc
+ ,- .
≡l
⎛ ⎞
du c
1 dc ∂y ∂ g (h , h )
+ ⎝β −q ⎠ − dF ( θ θ)
∂ g (h ,h) du (c ) ∂ h ∂ h
∂ h dc
+ ,- .
≡b

q ∂ 2
v ( y , θ , h )
− ∂ g (h ,h)
μ θ dθ . (A.15)
∂θ ∂ h
∂ h
The
terms
l and
b capture the cross-distortion induced by the wedges for labor and bequests, respectively. Since
du c /dc
E β du (c )/dc
− q = q 1−τbτ , the definition (12) of the wedge for bequests implies that b is given by (17).
b
The third term on the right hand side of (A.15) is the overall (gross) incentive effect of h. We now show that part of
it offsets l and that the remaining term corresponds to the net wedge i . To see this, we use results from Remark 4 to
rewrite
⎛ ⎞
∂ 2 A (θ,h)
∂ 2 v ( y , θ, h) ∂ 2 v ( y , θ, h) ∂ y ∂ v (l) l ∂ A (θ, h) ∂ A (θ, h) ⎝ ∂θ ∂ h A (θ, h ) ⎠
=− + 1− . (A.16)
∂θ∂ h ∂θ∂ y ∂h ∂l A2 ∂θ ∂h ∂ A (θ,h) ∂ A (θ,h)
∂θ ∂h
The first-order condition (A.11) for output implies that

⎡ ⎤
∂ v ( y ,θ ,h )
∂ 2 v ( y , θ , h ) ∂ y ⎣ ∂ y ∂ y
μ (θ )dθ = du (c )
− 1⎦ f θ dθ .
∂θ ∂ y ∂ h ∂ h
dc
Hence, using the decomposition (A.16) to compute the integral below, we find that, under assumptions [A1’] and [A2],

q ∂ 2 v ( y , θ , h )
− ∂ g (h ,h) μ θ dθ = −l + i , (A.17)
∂θ ∂ h
∂ h
where we have used that χ = 1 − A θ h (θ, h) A (θ, h) / [ A θ (θ, h) A h (θ, h)]. This decomposes the overall incentive effect of
human capital investment into two components. The first component, when evaluated at the optimal level of output, exactly
offsets the distortion for human capital investment induced by the labor wedge. This is why, when substituting (A.17) into
(A.15), we obtain (18). 2
Appendix B. Supplementary material
Supplementary material related to this article can be found online at https://doi.org/10.1016/j.red.2017.10.002.
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Review of Economic Dynamics 27 (2018) 1–26

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Review of Economic Dynamics

Human capital and optimal redistribution ✩

[A1] : U (ct , lt ) = u (ct ) − v (lt ) ,

2.2. The planner’s problem

( I C ) : U (x) ≥ U (x ◦ r) , for all r ∈R, (1)

We use xIC to denote the set of all allocations x satisfying (4).3

min  (x) , (5)

s.t. (i ) U (x) ≥ V ; (ii ) x ∈ xIC .

min  (x) , (8)

s.t. (i ) U (x) ≥ V ; (ii ) x ∈ xFOA .

2.3. Optimality conditions

where μ (θ) is the costate variable of the planner’s problem

Corollary 1. The effect of human capital on information rents is determined by

[A1’]: U (c , l) = u (c ) − v (l) , where v (l) = ζ lα , with ζ > 0 and α > 1,

ε vl = α − 1 and ρhθ = 1 − χ so that ∂ 2 v ( y , h, θ)/ (∂θ∂ h) ≥ 0 if and only if χ ≥ −α .

Wedges are deﬁned as the deviations

Fig. 1. Illustration of perturbation h > 0 with Cobb–Douglas productivity (χ = 0).

4.1. Calibration of decentralized economy

In the decentralized economy each family solves the maximization problem20

ln w (θ, h) = ln A (θ, h) = (1 − ξ ) ln h + ξ ln θ. (20)

Parameters Target Source

Production technology: y /l = θ ξ h1−ξ

Education cost: g (h , h) = κ ln(h )ς1 ln(h)ς2

Variable Data Model

4.2. Optimal allocation

s.t. bt +1 (θ t ) = (1 + r )bt − ct (θ t ) − g (ht +1 (θ t ), ht ) − T t (bt , yt (θ t ), ht +1 (θ t ), θ t −1 ),

bt +1 (θ t ) = (1 + r )bt − ct (θ t ) − g (ht +1 (θ t ), ht ) + δ yt 1−t y + L t (ht +1 , ht ) − D t (bt , yt , ht +1 , L t −1 , yt −1 ).

Appendix A. Analysis of the planner problem and proofs

ω (θ) = U (c (θ) , y (θ) , h, θ) + β V (θ) , (A.1)

∂ v ( y (θ) , h, θ)/∂ y (θ) μ (θ) ∂ 2 v ( y (θ) , h, θ)

For ∂ 2 U (·) / (∂ c (θ) ∂θ) = 0, equation (A.9) implies

where we use that

Remark 4. Under assumptions [A1’] and [A2]:

∂ 2 v ( y , h, θ) ∂ 2 v (l) ' y (2 ∂ A (θ, h) ∂ A (θ, h)

Under assumptions [A1’] and [A2], ε vl = α − 1 and ρhθ = 1 − χ so that

Proof of Corollary 1. Follows immediately from Remark 4 above. 2

Proof of Remark 2. Bequests. The ﬁrst-order condition for bequests reads

Labor supply. The ﬁrst-order condition for labor supply reads

Corollary 2. Under assumption [A1’] and [A2]

where α = ε −1 + 1 and ε denotes the Frisch elasticity of labor supply.

Thus, (16) implies that at the solution of the planner’s problem,

τl du (c ) /dc ∂ 2 v ( yh, θ) μ (θ)

τl du (c ) /dc ξ θ χ −1 ∂ v (l) μ (θ)

where we have substituted in μ(θ) using (A.13). 2

The ﬁrst-order condition (A.11) for output implies that

Appendix B. Supplementary material

Supplementary material related to this article can be found online at https://doi.org/10.1016/j.red.2017.10.002.

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min (x) , (5)

min (x) , (8)

Fig. 1. Illustration of perturbation h > 0 with Cobb–Douglas productivity (χ = 0).