Executive summary

Ensuring that all individuals can develop the skills needed to productively participate in the economy is necessary for inclusive economic growth. Investing in skills can expand the productive capacity of the economy and at the same time reduce inequality by ensuring that all members of society have the opportunity to fulfil their productive and creative potential. Improving the level of skills across the economy has positive impacts for individuals and society as a whole. For many individuals, human capital represents the most valuable asset they will possess in their lifetime.

The tax system impacts the ability of individuals to develop skills in a variety of ways. The revenues that taxes raise can be used to finance direct investments in skills. The tax code can treat labour and capital income differently, which can create incentives to invest in physical instead of human capital. Equally, the tax system can impact the financial incentives of individuals to develop, activate and use their skills efficiently in the labour market.

Better skill levels lead to higher wages and stronger employment prospects for workers, higher productivity and profits for businesses, and higher growth rates and tax revenues for governments. However, financing this spending is challenging for many OECD countries, especially in the context of high levels of public and private debt, and debate continues about how the costs of skills investments should be equitably and efficiently shared between governments, individuals, and businesses. A principal mechanism for this sharing of costs and benefits is the tax system.

This study assesses the way that taxes and other policy levers impact skills investments. While the effects of the tax system on investment in physical capital have been widely studied, investment in human capital has received less attention. This study presents indicators that measure the impact of tax and spending policy on individuals’ incentives to invest in skills. These indicators take into account the financial costs of skills investments for individuals such as lost after-tax earnings and tuition fees, as well as the costs borne by governments such as grants, scholarships, lost taxes, and skills tax expenditures. The indicators also incorporate the returns to skills investments for individuals and governments through higher after-tax wages and higher tax revenues respectively.

The first indicator measures how much an individual’s earnings need to increase before they recover the costs of a skills investment over their remaining years in the workforce. The second indicator is an effective tax rate on skills, which measures how much taxes raise or reduce the net returns to skills investments for an individual. The third indicator measures the returns to skills investments for governments, comparing the government’s costs of educating an individual to the government’s expected returns in the form of higher tax revenues. These indicators are developed for individuals who will just break even on a skills investment, and for individuals who will earn a larger return. Investments financed with both debt and savings are examined.

These indicators are modelled for a series of hypothetical skills investment scenarios, including a young university student and a mid-career worker. Results are presented for 29 OECD countries. The results in the study do not incorporate the impact of social security contributions; only personal income taxes are incorporated. Some of the key insights of the study include:

Tertiary education is a financially attractive investment for individuals: Based on the current tax, scholarship, and tuition policy mix, the results show that the wage premium earned by a university student in the current labour market is above – often well above – what is required to break even on the costs of tertiary education.
Governments recoup the costs of their investment in tertiary education on average through higher tax revenues on higher wages from more highly skilled workers: The extra income taxes paid over the lifetime of an average student more than cover government costs of educating that student. For some countries – though not all – the results suggest that increasing tertiary education spending would be self-financing in terms of income tax revenue alone.
For individuals whose returns to skills are lower, future expected income tax revenue may not cover governments’ costs of tertiary education: This is especially true where government spending on tertiary education is currently high. For governments to break even financially from increased skills spending, this spending should be targeted to encourage those skills investments where returns will be highest.
The effective tax rate on skills depends on how much the individual’s wage rises after the skills investment: For a tertiary student who just breaks even on the costs of their investment over their lifetime, tertiary education is comparatively lightly taxed; the tax system accounts for about 4% of the amount of extra earnings needed to break even on a skills investment. High-return skills investments are taxed more heavily than low-return skills investments. For an average rate of return on a tertiary education in the OECD, the tax system reduces the net returns by 19% on average.
Governments provide many tax expenditures to support investment in skills, such as tax deductions of skills expenses, or tax exemptions for scholarship income: The study argues that a careful case-by-case analysis of these provisions is needed, and suggests that good design is important in ensuring their effectiveness. Skills tax expenditures often provide larger benefits to those with larger taxable incomes, and to those in secure employment relative to those in casual employment. They may provide less assistance to those who are credit constrained, who are more likely to be from lower income households. Moreover, evidence of their impact on wages and employment is mixed.
Some design aspects of skills tax provisions may reduce labour market flexibility, exacerbate skills mismatches and represent a drag on productivity: Existing skills tax expenditures are often only available for training connected to a workers’ current employment, and may be ineffective in assisting workers who need or want to change careers.
Tax policies that encourage skills development and activation are complementary: Those who are more likely to develop skills are more likely to use them in the labour market, and those who work more and for longer have higher incentives to invest in skills. Tax policies that increase both skills investments and skills activation levels pay double dividends, particularly for groups with lower labour market participation such as women and older workers.
Ensuring access to skills for those who are credit constrained is crucial: Skills are unlike physical capital because they cannot be used as collateral to finance an investment. This may mean that skills investments with positive returns are not undertaken. Income-contingent loans may be an efficient and equitable approach to addressing these issues.

The study provides a number of important messages for governments and policy makers. First, the study demonstrates the importance of coherent policy mixes to encourage skills investments. Where governments tax away the returns to skills through higher taxes, it is important that public expenditure in support of skills is used to make skills investments sufficiently attractive. Where spending on skills by governments is lower, it is important that high taxes do not act as a large disincentive to invest. In all cases, the burden of the tax system on human capital investment should be considered by both tax policy makers and skills policy makers. Finally, the study presents a clear message to governments that the costs of failing to invest in skills will have consequences in the years ahead. A failure to invest in skills today will not only impede the economic participation of individuals and restrain productivity growth, but will reduce future expected tax revenues, increase future expected levels of social expenditure, and jeopardise future inclusive economic growth prospects.