The taxation of human capital

The tax and benefit system and education finance regime alter the value of human capital investments (e.g. education) by treating up-front costs, forgone earnings and future returns differently, and by insuring against earnings risk. In so doing, they affect the incentive to invest in human capital compared with not investing, and compared with other kinds of investment, such as financial investments. These are potentially important distortions that policymaking needs to take into account. The overall aim of this project is to use Understanding Society and British Household Panel Survey data, together with lifecycle modelling techniques, to provide new evidence on how the returns to human capital investments are distorted by actual and hypothetically-reformed UK tax and benefit systems and education finance regimes (including those in Scotland, Wales and Northern Ireland). To that end, we will address the following research questions: - How are investments in human capital taxed? - How do tax rates vary across different population subgroups and stages of life? - How effectively do taxes, benefits and the education finance regime insure against uncertainty in returns? - How do these features vary under different policy environments? - How do behavioural responses affect these results? Although some work has been done in this area, there remains much about the way that the tax and benefit system and education finance regime treat human capital investments that we do not know. Existing work has the common disadvantage that it is all for example individuals in idealised settings. This means there is limited consideration of variation across individuals, no attention paid to uncertainty, rudimentary modelling of taxes and benefits and no allowance for the behavioural effect of policies. These are important limitations, which our proposed approach will address. We will consider two types of human capital investment - education and labour market experience - and use two measures of how investments in human capital are taxed - an effective tax rate (ETR) and a participation tax rate (PTR). The ETR measures how much the internal rate of return to investment is affected by taxes, benefits and subsidies. This is the measure that has been used previously to describe, e.g. how the tax system treats the return to saving held in different assets. The PTR describes what proportion of the return to investment is lost due to higher taxes and lower benefits, possibly offset by subsidies. This has been widely used in the literature on financial work incentives. Our analysis will be for the UK and will be based on the Understanding Society and British Household Panel Survey (BHPS) datasets, supplemented with published data on educational spending per pupil from Government departments and agencies (e.g. the Education Funding Agency) and previous IFS work, and information about education-related expenses from the Student Income and Expenditure Survey. In the first stage of the project, we will use these data to produce descriptive analysis of employment, earnings and human capital investment costs. In the second stage, we will use the data and the results of the first stage to estimate how investments in human capital are taxed. This will be based on a lifecycle model of education, employment and saving choices that will allow us to calculate the ETRs and PTRs described above. This research represents a significant advance over the current literature, providing accurate and detailed estimates of the tax rates on investment in human capital and developing a methodology that can be applied in other settings. We also anticipate having significant impact on policymakers, improving understanding over how the tax and benefit system and education finance regime affect incentives to accumulate human capital, and affecting future policy decisions. We will exploit project partners in BIS and HMRC to ensure these impacts are realised.