Optimal progressive taxation in a model with endogenous skill supply

For a reforming government intent on improving efficiency, a natural way to discriminate between alternatives is via optimal taxation. In light of this, we examine quantitatively the extent of progressivity or regressivity of optimal labour income taxation in a model with skill heterogeneity, endogenous skill acquisition and a production sector with capital-skill complementarity. We find that wage inequality driven by the resource requirements of skill-creation implies progressive labour income taxation. In particular, in the steady-state, skilled labour income is taxed about forty percent more than unskilled labour income. We further find that the optimal transition path from the exogenous to optimal policy steady-state also exhibits progressive labour income taxation. These results are explained by a lower work time elasticity for skilled versus unskilled labour which results from the introduction of the skill acquisition technology.