BEYOND EDUCATION AND FAIRNESS: A LABOR MARKET TAXATION MODEL FOR THE GREAT GATSBY CURVE

I. INTRODUCTION An intergenerational income elasticity (HE) for a particular country can be thought of as the fraction of a 1% permanent income increase given to a parent that is observed, on average, in the permanent income of a child. Thus, estimates of the IIE are sometimes viewed as a summary measure of the intergenerational economic mobility in a particular country. In a 2012 speech, then chairman of the U.S. Council of Economic Advisers, Alan Krueger, emphasized the importance of the strong, positive, cross-country correlation between contemporary measures of economic inequality and economic mobility, as measured by the IIE. He further dubbed a graph of this relationship the "Great Gatsby curve." Although this witty designation is novel, the correlation it refers to has been the subject of a great deal of economic research. Indeed, even before the availability of reliable IIE data for many countries, Seshadri and Yuki (2004), as well as Erosa and Koreshkova (2007), provided intergenerational models, calibrated to the U.S. economy, that explored potential taxation and transfer mechanisms linking contemporary inequality and mobility. However, as accurate estimates of this relationship have become available for an increasing number of countries, applied researchers investigating the cross-country divergence of IIEs (Bjorklund and Jantti 2009; Blanden 2009; Corak 2013b) have been more heavily influenced by the theoretical model proposed by Solon (1999), as later clarified and expanded in Solon (2004), which builds on the fundamental model of human capital transmission proposed by Becker and Tomes (1979). The augmented Solon model deliberately focuses on one potential mechanism underlying differences in the IIE. More specifically, differential cross-country intergenerational mobility primarily arises, in the Solon model, from the differential government responses to the borrowing constraints faced by the parents of poor children. While all parents can choose to make human capital investments in their children, they can only finance these investments out of their own lifetime earnings, and are unable to borrow against the future earnings of the child. These borrowing constraints lead to less investment in human capital by poor parents and subsequently lower earnings for poor children. The model also allows governments to address this inequality by investing in the human capital of the future generation in a progressive manner (more investment at lower parental incomes). Thus, variations in government policy choices over educational investment combine with existing constraints created by income inequality to produce varying mobility across countries. This model is particularly attractive to applied researchers because it provides a clear, policy-relevant interpretation of the equation parameter most commonly used in the actual empirical estimation of IIEs. Another attractive feature of the Solon model is that it makes a number of testable empirical claims about this HE parameter. Intergenerational mobility should be positively correlated with cross-sectional mobility, as well as with government educational investment in the poor. The HE should also be higher in countries where labor markets provide greater returns to schooling. Empirical work in highly developed countries has provided preliminary evidence supporting these claims. For example, Ichino, Karabarbounis, and Moretti (2011) find a negative relationship between government spending on education (particularly at the primary level) and HE across a dozen countries, while Mayer and Lopoo (2008) find the same pattern holds across U.S. states. Blanden (2009) also finds this pattern and goes further to show positive cross-country correlations between HE and both cross-sectional inequality and the returns to education. (1) While many predictions of this class of model are borne out in the data, there is less evidence in support of the primary mechanism it articulates to produce cross-country variation in intergenerational mobility, namely a differential response to the borrowing constraints faced by some families in childhood human capital markets. …