The taxation of human capital

Lead Research Organisation: Institute for Fiscal Studies
Department Name: IFS Research Team

Abstract

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.

Planned Impact

This project has the potential for significant impact. Anticipated impact for academics is set out in the Academic Beneficiaries section. Here we describe the impact on four other groups of beneficiaries: policymakers, other groups engaged in policy debates, the wider public and project researchers themselves.

The first group of beneficiaries is policymakers, especially those making personal tax policy at HMRC and HM Treasury, those responsible for issues relating to education participation, labour markets and skills at BIS, and those working on benefit design at DWP. We also expect analysts working in these areas in the devolved governments of the UK to benefit. Such policymakers will benefit because they will gain a better understanding of how the tax and benefit system and education finance regime affect returns to investing in education and labour market experience. Previous work has argued in favour of designing taxes, benefits and education subsidies so as not to distort decisions over education and experience accumulation. Our results will highlight the extent to which the current system deviates from neutrality and enable reforms to tackle the biggest problem areas. We will also contribute to policymakers' understanding of the nature of progression in the labour market, and of socio-economic inequalities in access to higher education and in earnings (e.g. one reason for poor earnings progression might be the weak incentives to invest in human capital that some individuals face).

Second, international organisations such as the OECD, European Commission and IMF will also benefit. These organisations have a specific interest in tax design issues and in empirical estimates of effective tax rates across different activities and countries. We expect the OECD to be particularly interested given its previous work in the area. These organisations will benefit in ways similar to policymakers: through a better understanding of how the policy environment affects the return to investing in education and labour market experience, leading to improved analysis and recommendations to policymakers. Researchers in these organisations will also benefit from using our new methodology.

Third, other groups engaged in policy debates, such as the HEFCE, HESA, OFFA, the CBI, CIOT, the Low Incomes Tax Reform Group and public policy think tanks, will benefit. These groups will benefit through seeing the scale of returns to investment in human capital and the way in which the policy environment strengthens or weakens investment incentives. This will allow them to focus their activities more effectively and provide better advice and information to individuals and other target audiences such as policymakers. As a result, they also stand to gain from better evidence-based policymaking.

The fourth group is the wider public. This especially includes individuals making education and labour market decisions because our results will help them understand how returns are taxed. In addition, these individuals stand to benefit from better policymaking. For example, if the policy environment moves closer towards a neutral treatment of human capital investments, then they will not have their decisions distorted artificially by the unintended effects of tax, benefit and education policies. In addition, there is also potential for the public to benefit more broadly through improved economic performance resulting from better policymaking.

Finally, project researchers stand to benefit beyond the impacts on academics outlined in the Academic Beneficiaries section. All project researchers - but particularly the early career researcher - will have excellent career development opportunities, including the chance to develop economic modelling skills as well as openings to make links with policymakers, present to academic and general audiences and to make media appearances. These skills will be valuable for future research and employment in other sectors.

Publications

10 25 50
 
Description In this project we have developed a measures of the dynamic return to work, which can arise through the human capital formation inherent in working spells, and how this is return is affected by taxes and benefits. In doing so we bring the insights from the literature on dynamic labour supply to the issue of estimating the financial return to work and how it is taxed, where the past literature has focused on the current period return. We do this with two new summary measures: the forward-looking replacement rate (FLRR), which measures the dynamic return to working at all, and the forward-looking participation tax rate (FLPTR), which measures the impact of personal taxes and transfers on the dynamic return to work. We implement these using simulated data from a sophisticated, structural dynamic model of female education, labour supply and human capital formation during the working life.

We find that the returns to work are much higer if one takes into account how work accumulates skills than a static measure would imply. At the start of working life, the expected FLRR and static RR differ by at least 5 percentage points for more than two thirds of women, and by over 10 percentage points for over a third of women. These results are driven by returns to experience. In contrast, we find a dynamic perspective makes relatively little difference to the extent to which personal taxes and transfers reduce the return to work, with the expected FLPTR and static PTR differing little for most women in our data. This mainly reflects the fact that that the UK tax and benefit system tends to treat the future returns to working today similarly to how it treats the current-period return.

We then look at investments in University education, its returns and how these are treated by the tax and benefit system under different University funding regimes. This research is still on-going but we have interesting initial results. We used the changes in University funding that happend recently in the UK to show that the choice of whether to enrol in education, and the type of university and course young adults select into, respond to the incentives to invest. In particular, highly academic students coming from low socio-economic backgrounds are significantly deterred from investing in University education when the perceived cost of the investment increases, even if the cost is realised only in the future and is means-tested.
Exploitation Route We are following up on our research on the drivers of investmens in University education and how they relate to the tax treatment of returns to education to develop a formal framework where we can study the drivers of individual choices, how they vary with the socio-economic background and school performance of students, and what the returns to different types of University education are. This research avenue has been discussed with other academics and policy makers, both in the UK and internationally, and is raising huge interest.
Sectors Education,Government, Democracy and Justice

 
Description Meeting (policy advice) with officials from the Ghana Tax Policy Unit and Revenue Authority
Geographic Reach Africa 
Policy Influence Type Participation in a advisory committee
Impact Meeting (policy advice) with officials from the Ghana Tax Policy Unit and Revenue Authority. Jonathan Shaw 09/06/2016
 
Description Meeting with HM Revenue and Customs officials about evaluating the impact of Making Tax Digital for Business
Geographic Reach National 
Policy Influence Type Participation in a advisory committee
Impact Meeting with HM Revenue and Customs officials about evaluating the impact of Making Tax Digital for Business. Stuart Adam, Jonathan Shaw 21/07/2016
 
Description Meeting with HM Treasury officials about personal tax strategy
Geographic Reach National 
Policy Influence Type Participation in a advisory committee
Impact Meeting with HM Treasury officials about personal tax strategy Stuart Adam. Paul Johnson 06/05/2016
 
Description Meeting with HM Treasury officials about tax reliefs
Geographic Reach National 
Policy Influence Type Participation in a advisory committee
Impact Meeting with HM Treasury officials about tax reliefs. Stuart Adam, Thomas Pope 14/07/2016
 
Description Meeting with HM Treasury officials about taxation and the employed/self-employed/incorporated boundary
Geographic Reach National 
Policy Influence Type Implementation circular/rapid advice/letter to e.g. Ministry of Health
Impact Stuart Adam Helen Miller 04/07/2016
 
Description Meeting with HMRC about CGT reforms/capital gains realisations
Geographic Reach Local/Municipal/Regional 
Policy Influence Type Participation in a advisory committee
Impact Meeting with HMRC about estimating the impact of CGT reforms on capital gains realisations. Jonathan Shaw . Stuart Adam 22/02/2016
 
Description Meeting with Jonny Mood from NAO to provide expert input on tax evasion
Geographic Reach Local/Municipal/Regional 
Policy Influence Type Participation in a advisory committee
Impact Meeting with Jonny Mood from NAO to provide expert input on tax evasion
 
Description Meeting with Office for Budget Responsibility about measuring work incentives
Geographic Reach Local/Municipal/Regional 
Policy Influence Type Participation in a advisory committee
Impact Meeting with Office for Budget Responsibility about measuring work incentives. Stuart Adam, Andrew Hood, Robert Joyce , Carl Emmerson 05/04/2016
 
Description Office for Tax Simplification stakeholder discussion on priorities for tax simplification
Geographic Reach National 
Policy Influence Type Participation in a advisory committee
Impact Stuart Adam
 
Description Participation in an advisory committee (Australian Treasury, Social Services)
Geographic Reach Australia 
Policy Influence Type Participation in a advisory committee
Impact Participation in an advisory committee - Meeting in London with Australian Treasury about taxation of saving and modelling lifetime outcomes (22/11/2016) Participation in an advisory committee - Meeting in Canberra with Tax Analysis Division at Australian Treasury about modelling tax reforms (21/02/2017) Participation in an advisory committee - Meeting in Canberra with Chris Murphy from Independent Economics about Australian Treasury modelling capability (21/02/2017) Participation in an advisory committee - Meeting in Canberra with Tax Analysis Division at Australian Treasury about modelling lifetime outcomes (21/02/2017) Participation in an advisory committee - Meeting in Canberra with Australian Treasury and Department of Social Services about modelling lifetime outcomes (21/02/2017) Participation in an advisory committee - Meeting in Canberra with Macroeconomic Modelling and Policy Division at Australian Treasury about modelling tax reforms (22/02/2017)
 
Description Policy advice with officials from the Ghana Tax Policy Unit and Revenue Authority
Geographic Reach Africa 
Policy Influence Type Participation in a advisory committee
Impact Meeting (policy advice) with officials from the Ghana Tax Policy Unit and Revenue Authority Adam Stuart 09/06/2016
 
Description Provided comments on OBR Fiscal Sustainability Analytical paper on health spending
Geographic Reach National 
Policy Influence Type Participation in a advisory committee
Impact Discussed with economists on the OBR a draft of a paper that looked at productivity in health spending, and factors that might effect future health spending. This resulted in a set of comments on an analytical paper, with changes made to the final version (published 22/09/2016)
 
Description Telephone meeting with Scottish Parliament Finance Committee clerk about using Scotland's new tax powers
Geographic Reach National 
Policy Influence Type Implementation circular/rapid advice/letter to e.g. Ministry of Health
Impact Telephone meeting with Scottish Parliament Finance Committee clerk about using Scotland's new tax powers. David Phillips 04/05/2016
 
Description Research visit from Mazhar Waseem (Manchester) 
Organisation University of Manchester
Country United Kingdom 
Sector Academic/University 
PI Contribution Academic input
Collaborator Contribution Academic input
Impact Academic input
Start Year 2016
 
Description Research visit from Peer Skov (Copenhagen) 
Organisation University of Copenhagen
Country Denmark 
Sector Academic/University 
PI Contribution Academic input
Collaborator Contribution Academic input
Impact Academic input
Start Year 2016
 
Description Two-week research visit from Peter Haan (DIW) in August 2016 
Organisation German Institute for Economic Research
Country Germany 
Sector Charity/Non Profit 
PI Contribution Academic input
Collaborator Contribution Academic input
Impact Academic input
Start Year 2016
 
Description FORTAX: a tax and benefit microsimulation library 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach National
Primary Audience Policymakers/politicians
Results and Impact Discussion
Year(s) Of Engagement Activity 2012
 
Description Higher Education Financing and Sorting with Capacity Constraints 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach National
Primary Audience Other audiences
Results and Impact Two presentations given at UCL in February and May 2018.
Year(s) Of Engagement Activity 2018
 
Description Participation in an advisory committee: Australian treasury modelling capability 
Form Of Engagement Activity A formal working group, expert panel or dialogue
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Other audiences
Results and Impact On 21 February 2017 Jonathan Shaw attended a meeting in Canberra with Chris Murphy, from the Independent Economics about Australian Treasury modelling capability.
Year(s) Of Engagement Activity 2017
 
Description Participation in an advisory committee: modelling lifetime outcomes 
Form Of Engagement Activity A formal working group, expert panel or dialogue
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Other audiences
Results and Impact Jonathan Shaw attended meetings on 21 and 22 February 2017 in Canberra about "modelling lifetime outcomes" with the:

• Australian Treasury
• Department of Social Services
• Tax Analysis Division at Australian Treasury
Year(s) Of Engagement Activity 2017
 
Description Presentation: Distributional analysis for policy development: a lifetime perspective 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Other audiences
Results and Impact Jonathan Shaw delivered this presentation in Canberra to the on 21 February 2017 to the:

• Australian Treasury
• Department of Social Services
• Academics from Australian National University
Year(s) Of Engagement Activity 2017
 
Description The role of universities in social mobility in the UK 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach International
Primary Audience Other audiences
Results and Impact Presentations given in October 2018 at Maynooth University, Ireland, Lancaster University, UK, 3rd IZA Conference on the Economics of Education, Germany, University of California Irvine, US.
Year(s) Of Engagement Activity 2018
 
Description The taxation of labour-market returns to education and experience 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach National
Primary Audience Policymakers/politicians
Results and Impact Workshop on 'The taxation of labour-market returns to education and experience' at BIS
Year(s) Of Engagement Activity 2016
 
Description The taxation of labour-market returns to education and experience 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach National
Primary Audience Policymakers/politicians
Results and Impact Presentation on 'The taxation of labour-market returns to education and experience' to the Scottish Government.
Year(s) Of Engagement Activity 2016
 
Description The taxation of labour-market returns to education and experience 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach National
Primary Audience Policymakers/politicians
Results and Impact Workshop on 'The taxation of labour-market returns to education and experience' at HMRC
Year(s) Of Engagement Activity 2016
 
Description The taxation of labour-market returns to education and experience 
Form Of Engagement Activity A talk or presentation
Part Of Official Scheme? No
Geographic Reach National
Primary Audience Policymakers/politicians
Results and Impact Workshop on 'The taxation of labour-market returns to education and experience' at the Welsh Government
Year(s) Of Engagement Activity 2016
 
Description Workshop: To develop survey questions about subjective returns to investment in human capital 
Form Of Engagement Activity Participation in an activity, workshop or similar
Part Of Official Scheme? No
Geographic Reach National
Primary Audience Other audiences
Results and Impact This workshop was held at the Centre for Longitudinal Studies and presented by Jonathan Shaw on 30 November 2016.
Year(s) Of Engagement Activity 2016