Equalizing Outcomes vs. Equalizing Opportunities: Optimal Taxation when Children’s Abilities Depend on Parents’ Resources
Executive Summary — Economists have long recognized that parents' resources and investment in their children may be key determinants of their children's outcomes. Recent evidence indicates that increasing the disposable incomes of poor parents raises the performance of their children on tests of cognitive ability. That finding suggests that current tax policy may affect the future distribution of underlying income-earning abilities in the taxpayer population. However, the dominant model of optimal taxation has been unable to take this effect into account. This study explores the implications for optimal policy of taking a more nuanced approach. Using a calibrated model to simulate optimal policy, the authors find that the optimal policy redistributes substantially more toward low-ability parents and earlier generations than does status quo policy. This paper may be the first to model this complexity and derive policy implications. Key concepts include:
- When poor parents have more disposable income, their children's performance improves and they have greater opportunity to succeed.
- An optimal tax policy will take advantage of this relationship to shape the distribution of ability over time.
- The gain outlined in the paper is equivalent to a permanent increase in disposable income for all generations of more than one percent.
- Choices by parents affect the abilities taken as given by their children, and these abilities in turn affect the set of choices available to children. This interaction is a central factor in optimal tax policy: It is the crux of the tradeoff between redistributing to the poor later and investing in their skills now.
- The interaction between natural ability and human capital investments is also relevant for issues such as optimal life-cycle tax and training policies and social insurance program design.
Empirical research suggests that parents' economic resources affect their children's future earnings abilities. Optimal tax policy therefore will treat future ability distributions as endogenous to current taxes. We model this endogeneity, calibrate the model to match estimates of the intergenerational transmission of earnings ability in the United States, and use the model to simulate optimal policy numerically. Optimal policy is more redistributive toward low-income parents than existing U.S. tax policy. The optimal policy increases the probability that low-income children move up the economic ladder, generating a present-value welfare gain of 1.28% of consumption in our baseline case.