UvA

Progressive income taxes moderate wage demands by trade unions and thereby reduce unemployment, but alsothey reduce incentives to acquire skills and lower productivity of workers. The optimal response of the governmentto this dilemma is to choose a system of progressive taxes and to (partly) subsidise investment in human capital. Acombination of generous education subsidies and steep tax rates is more likely to prevail the larger the power oftrade unions to set wages, the better the ability of the government to steer private efforts to educate, and thehigher the preference for equality between the employed and the unemployed. An empirical analysis for severalOECD countries gives similar results. A policy mix of high education subsidies and relatively progressive incometaxes is found in countries where union membership is significant and the replacement rate is high.