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Motivating Parents to Invest in Children

Final Report Summary - MPIC (Motivating Parents to Invest in Children)

Parents choose how many books to buy their children, how much time to spend reading to them, or whether to pay for private tutors for their children. It is an empirically established fact that parental investments are crucial in determining adult outcomes. Furthermore, governments do not have direct control over investment children receive at home, and as a result, cannot force parents to invest. Motivated by these observations, this project pursues a broad program at the intersection of macroeconomics and public economics that both contributes to the theoretical understanding of how fiscal policy (taxation and social security system) should be designed in order to encourage parental investments and provides practical recommendations that can be used by policymakers around the world.

Dr. Yazici has uncovered important results that have policy implications throughout this project. First, Dr. Yazici shows that in a world where parental investments are hard to monitor publicly, social security system and taxation of private savings accounts can be used effectively to provide parents with incentives to invest in their children. Specifically, Dr. Yazici builds a theoretical model where parental investment during childhood increases children’s odds of earning high incomes when they become adults and their parents become retired. Parents can also save for their old age through private saving accounts. In such a world, on the one hand, it is socially desirable to insure parents and children against the risk of children's low earnings by setting old age benefits to be equal for all parents and using redistributive taxation from high income children to low income ones. On the other hand, however, too much insurance would deteriorate parental incentives to invest in their children. Dr. Yazici shows that in the optimal social security system that follows from this trade-off, old age benefits depend on children’s adult earnings. Intuitively, making old age benefits depend positively on children’s income acts as an indirect subsidy on parental investments, thereby motivating parents to invest in their children. Furthermore, Dr. Yazici shows that for such a social security scheme to provide parental incentives, it has to be accompanied by a specific taxation scheme on parents' private savings accounts. According to this scheme, the tax rate on the returns to parents’ retirement savings should also depend on children’s adult earnings. Dr. Yazici also shows that the expected tax on these savings is zero, meaning these taxes are not in effect to collect revenue, but they are needed solely to provide the right incentives for parental investments.

In social security systems that are in place in most countries of the world, the old age benefits people face and the taxes they pay on their retirement savings are independent of their children’s adult earnings. This work suggests that this existing policy might be suboptimal as it is hurtful to parental incentive provision, resulting in lower than optimal levels of parental investment in children. As such, this work calls for a substantial reforming of social security systems by making parents' old age outcomes depend on children's adult performance.

Dr. Yazici also calibrates the theoretical model outlined above to the U.S. economy and conducts a quantitative analysis to find out the exact form of the optimal dependence of social security payments and savings taxes on offspring's adult earnings. This quantitative analysis is also important because it shows the extent of welfare improvements proposed policy change achieves. Dr. Yazici finds that welfare gains of a reform from current social security system to the one proposed in the project might be substantial.

Second, from Cunha and Heckman (2006), we know that home investments and schooling are complementary to each other in determining children’s adult earnings. Taking this as his starting point, Dr. Yazici also scrutinizes theoretically how schooling policy should be designed along with fiscal policy in order to optimally balance the insurance versus parental incentives trade-off. An important distinction of schooling from home investments is that it can be observed by government. This means government can force parents to certain levels of schooling or can directly affect parents’ schooling choice via taxes or subsidies on schooling. The main result here is that government has to complement optimal social security and taxation schemes with a tax on returns to schooling to make parents choose the right amounts of schooling and home investments. Since the return to schooling materializes as children’s adult income, government needs to tax children’s income to provide parental incentives. Dr. Yazici finds that depending on the assumptions about the degree of complementarity of schooling and home investments, parental incentives might call for more or less progressivity of the marginal income tax schedules.

Finally, there is a host of studies from developmental psychology literature which shows that non-cognitive skills, such as the ability to self-control, motivation, persistence, and time preference are moldable in childhood through parental investments. As a part of this project, Dr. Yazici started collaborating with Prof. Nicola Pavoni of Bocconi University to analyze how fiscal policy (taxation of parental transfers and life-cycle savings) should be jointly designed with parental investment subsidies in a world where parental investment is crucial in shaping a particular facet of children’s non-cognitive skills, the ability to self-control.

As a result of this collaboration, Dr. Yazici and Prof. Pavoni find that, due to a pecuniary externality, parental investment to decrease children’s self-control problems is higher than what is socially optimal, and hence, parental investments should be taxed, not subsidized. Dr. Yazici and Prof. Pavoni also find that bequests and inter vivos transfers should be taxed, as long as parental investments do not solve self-control problems completely. This result makes a significant contribution to the policy and academic debate on transfer taxation, which has long been a highly controversial issue. Proponents of transfer taxation advocate its role in redistributing wealth whereas opponents raise efficiency concerns due to disincentives such as discouraging capital accumulation, reducing incentives to work, bankrupting small family firms, inter-alia. In this paper, Dr. Yazici and Prof. Pavoni provide a novel, pure efficiency argument for taxing bequests and inter vivos transfers.

Dr. Yazici and Prof. Pavoni also analyze life-cycle savings taxation in the presence of self-control problems. They show that if, as suggested by personality psychologists, agents’ ability to self-control increases concavely with age, then savings should be subsidized and the subsidy should decrease with age. They also show that allowing for age-dependent self-control problems creates large effects on the level of optimal subsidies.