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.

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.