We formulate a two-period life-cycle model of saving, labor supply, and human capital investments when individuals differ in ability and initial wealth. Borrowing constraints prevent individuals to optimally smooth consumption over the life-cycle and to optimally invest in human capital. We show that the optimal linear income tax is positive - even in the absence of any redistributional concerns. A progressive income tax is efficient because it relaxes borrowing constraints by redistributing resources from the unconstrained to the borrowing constrained stages of the life-cycle. Hence, consumption is smoothed better and investments in human capital increase. The progressive income tax is a second-best instrument to correct the non-tax distortion in the capital market. The equity-efficiency trade-off is therefore less severe when progressive income taxes mitigate capital market imperfections. Simulations demonstrate that optimal income taxes are substantially higher when they alleviate credit constraints.
labor taxation human capital investment credit constraints