Optimal student loans and graduate tax under moral hazard and adverse selection

Abstract

type="main"> <p>We characterize the set of second-best “menus” of student-loan contracts in an economy with risky labor-market outcomes, adverse selection, moral hazard, and risk aversion. We combine student loans with optimal income taxation. Second-best optima provide incomplete insurance because of moral hazard. Optimal repayments must be income contingent, or the income tax must comprise a graduate tax. Individuals are ex ante unequal because of differing probabilities of success, and ex post unequal, because taxation trades off incentives and redistribution. In addition, second-best optima exhibit an interim equalization property: the poststudy but prework expected utilities of newly graduated student types must be equal.