This study analyzes an overlapping generations economy with multiple family dynasties in which the abihty levels of children are random and unobservable. Each parent allocates his income between consumption and investment in the education of his child. Each child, in turn, decides how much effort toexert in school on the basis of his perceived marginal returns to schooling, a perception shaped in part by the child's perception ofthe marginal returns to "schooling attained by his parent. The income tax policies available to government range from hbertarian (no redistribution) to perfectly egalitarian (equalization of after-tax family incomes in each period), where all income transfers are financed by current tax receipts. It is shown that policies resulting in small income transfers from richer to poorer families can increase social welfare by enabling poorer families to invest more optimally in their children, and by reducing uncertainty about future income...
Orazem, Peter F. and Tesfatsion, Leigh, "Human Capital Investment And The Locally Rational Child" (1993). ISU Economic Report Series. 32.