Consumption vs. income taxes when private human capital investments are imperfectly observable

This paper considers optimal taxation in an endogenous growth model where private education investments are imperfectly observable. Consumption taxation is better than labor income taxation for public provision of goods unless educational investment is completely unobservable. If subsidies are feasible for observed education investment, the consumption tax rate is independent of the degree of observability but the subsidy rate is higher the lower is the observability. If subsidies are not feasible, the consumption tax rate is lower the more limited is the observability. Optimal tax rates for goods that provide consumption and education investment simultaneously are below normal rates for observed pure consumption. Growth and welfare are positively related to (independent of) the degree of observability without (with) subsidies.