The Welfare Cost of Income Taxation in the Presence of Human Capital Accumulation: A Sufficient Statistics Approach

The recent literature on the welfare cost of income taxation (e.g., Feldstein, 1999; Chetty, 2008) extends analysis of the scope of distortions from a traditional labor supply distortion to tax avoidance and evasion and debates the importance of “tax-sheltering” activities. The resulting implication is that the welfare cost of income taxation may not be substantial, lending support to high optimal tax rates (e.g., Saez, 2001). We reexamine this implication from a long-term perspective: by considering a neglected distortion in human capital investment, we present that leaving out human capital investment would understate the true welfare cost of income taxation. Our survey of the related literature combined with our analysis of the CPS data reveals that underestimation of the welfare cost is substantial indeed, given a non-negligible price elasticity of investment in schooling. Our findings, based on a sufficient statistics approach, suggest the following: (i) the long-run welfare cost is larger than existing estimates, by more than 60%; and (ii) the share of the distortions arising from overall supply-side behaviors is larger than implied in the existing literature. Another form of skill formation, learning-by-doing (LBD), is also found to have similar implications.