Progressive Taxation versus College Subsidies with College Dropout

This paper examines what the optimal policy is against the rising skill premium in a heterogeneous agent macroeconomic model in which agents make endogenous enrollment and dropout decisions. Some college enrollees in the model endogenously drop out after learning ability during college. Using this model, I derive the optimal progressive labor income tax and optimal college subsidies separately and compare the social welfare. While the effect of college subsidies is smaller than the case without learning ability, the optimal college subsidies improve social welfare more than the optimal progressive labor income tax.