Catalyzers for Social Insurance: Education Subsidies vs. Real Capital Taxation

To analyze the optimal social insurance package, we set up a two-period life-cycle model with risky human capital investment, where the government has access to labor taxation, education subsidies and capital taxation. Social insurance is provided by redistributive labor taxation. Moreover, both education subsidies and capital taxation are used as catalyzers to facilitate social insurance by mitigating distortions from labor taxation. We derive a Ramsey-rule for the optimal combination of these two instruments. Relative to capital taxation, optimal education subsidies increase in their relative effectiveness to boost labor supply and in households' underinvestment into education, but they decrease in their relative net distortions. For their absolute levels, indirect complementarity effects, i.e., influencing the effectiveness of the other instrument, do matter. Generally, a decrease in capital taxes should go along with an increase in education subsidies.