DP10267 Human Capital and Optimal Redistribution
We characterize optimal redistribution in a dynastic economy with observable human capital and hidden ability. The government can use education to improve the insurance-incentive trade-off because there is a wedge between human capital investment in the laissez faire and the social optimum. This wedge differs from the wedge for bequests because: (i) returns to human capital are risky; (ii) human capital may change informational rents. We illustrate numerically that, if ability is i.i.d. across generations, human capital investment declines in parents? income in the social optimum, and show how this optimum can be implemented with student loans or means-tested grants.