Optimal taxation with externalities of consumption and education spending

Abstract

We investigate optimal taxation when a person’s utility decreases in others’ consumption and school quality increases in others’ education spending. Education externalities reduce education spending and schooling time from optimal levels, whereas consumption externalities cause high consumption relative to leisure and public goods. Internalizing education externalities supports education subsidies but opposite taxes on consumption and labour income. Internalizing consumption externalities supports consumption taxes but equal rates of labour income taxes and education subsidies. Internalizing both externalities justifies higher education subsidies than labour income taxes and positive taxes on labour income and consumption. We also investigate quantitative implications for tax reform and government debt sustainability.