History-Dependent Individual Behavior, Polarization, and Pareto-Improving Activating Welfare

This paper assumes that human capital not only generates market incomes but is a direct source of utility as well. In an otherwise standard framework it is shown that the interaction between human capital and effort in raising human capital and in generating utility naturally leads to history-dependent optimal individual behavior. Depending on the initial distribution of skills, this history-dependence divides each group of otherwise identical households into two perpetually separated groups: one rich and educated, the other poor and uneducated. If the rich have a common interest in the education of the poor (for instance financing public goods), such polarized equilibria are typically Pareto-inefficient. While unconditional transfers only reduce the incentives of the uneducated to accumulate skills, it is shown that there exist activating tax-transfer systems that Pareto-dominate any non-redistributing tax-system and involve a negative marginal income tax on household income below a certain threshold.