Optimal Wage and Income Taxation with Wage Uncertainty

Optimal taxation in a two-period model with human-capital investment and second-period wage uncertainty is analyzed. A proportional tax on wages dominates lump-sum taxation and the socially-optimal level of human capital exceeds that which individuals choose. A tax on interest income may raise welfare by encouraging investment in human capital. The interest-income tax reduces the difference between returns to physical and human capital from individuals' inability to reduce human-capital risk through diversification. A positive interest-income tax rate may therefore be optimal, even with an optimal wage tax, by encouraging m ore investment in human capital. Copyright 1987 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.