Dynamics of Mirrleesian Taxation in the Education Race Model

Abstract

The wage premium of college workers relative to non-college workers, or the so-called college wage premium, is an important aspect of earnings inequality. This paper adopts the education race model to address the question: How should Mirrleesian taxation be set dynamically in response to the evolution of the college wage premium resulting from the race between technology (skill-biased technical change, SBTC) and education (increasing supply of skills)? It is shown that while the overall structure of optimal marginal tax rates becomes progressively less over time than it would be if only the force of technology were to exist, the overall structure becomes progressively more over time than it would be if only the force of education were to exist. The opposite outcomes arise mainly because increasing supply of skills keeps relaxing the incentive compatibility constraint by compressing the wage premium, whereas SBTC keeps tightening it by enhancing the wage premium. The race between technology and education gives rise to a tug of war, and the countervailing forces result in the evolving pattern of the college wage premium at the optimum deviating not much from that in the data.

Keywords: Optimal taxation, Education race model, SBTC, Relative supply of skills