Cutting Income Taxes is Useless if There Aren't Good Preschools

The availability and quality of non-parental care provide parents the ability to combine work and family life effectively. The Lisbon strategy set the goal of guaranteeing a place in day care services to at least 33% of children between 0 and 2. Many European countries, Italy included, are still lagging behind. Beyond being a complement to individual labor supply, day care services are also crucial to promote the formation of children's abilities.

The role of child care for children's human capital acquisition has been widely studied in the psychology and sociology literature. Economists have more recently recognized the importance of child care on skills' acquisition. This is documented by two recent strands of the literature. The first one describes the individual's skill formation as a dynamic process, characterized by strong complementarities between early and late investments in human capital. As there are critical and sensitive periods for the development of both cognitive and non-cognitive abilities, later remediation for early deficits in the formation of some important abilities is difficult and costly. A second strand of the literature looks at the importance of parental time, and especially maternal time, compared to other types of child care in producing children abilities. Recent contributions highlight that, on average, the substitution of maternal time with other child care sources produces negative effects on children's skills. However, they also show that this result masks some differences across alternative sources of child care and levels of maternal education: for instance, formal care (i.e. center-based day care and preschool) may have positive effects on children of poorly educated mothers. More generally, this literature suggests that including child care in the skill formation process is appropriate and that the impact of parental time and day care on the accumulation of human capital is type-specific.

These are the starting points of two recent contributions (A. Casarico, A. Sommacal, Labor, income taxation, human capital and growth: the role of child care, forthcoming in The Scandinavian Journal of Economics and A. Casarico, L. Micheletto and A. Sommacal, Intergenerational transmission of skills during childhood and optimal public policies, CESifo and Econpubblica working paper) where we analyse how the inclusion of child care in the human capital accumulation process influences the effects of labor income taxation and the optimal design of other policy instruments, such as day care subsidies.

Consider for instance a reduction of taxes on labor. It is generally thought that a reduction in taxation promotes growth, by strengthening the incentives to work. However, if lower taxes imply more time at work, they will generally also imply substituting other sources of child care for the reduced parental time spent with children. This substitution will in turn affect the quality of the early childhood environment, which is an input in the human capital production function. Thus, changes in taxation affect human capital accumulation also through their impact on child care choices. We find that for reasonable values of the parameters, the growth rate reacts less to cuts to labor income taxation when child care matters for the production of human capital. In other words, the existing literature may be overestimating the positive growth impact of a reduction to labor taxation. By how much? This crucially depends on the relative productivity of parental and non-parental time in determining the human capital of young children. If we interpret this relative productivity as a measure of the relative quality of day care services, our results suggest that this quality matters for assessing the impact of taxation on growth: the lower it is, the less favorable the growth impact of a tax cut. From this perspective, one can conclude that the role played by child care in the process of skill formation is relevant from a macroeconomic point of view, because it influences the long-term effects of taxation on growth.

The quality of day care services plays also an important role in reducing the transmission of inequality over time: the exposure to high quality day care services can increase the probability that a highly-talented child coming from a disadvantaged background will build up high human capital. According to our simulations, if a government sets its taxation policy disregarding this, it will cause a welfare loss that ranges from 0.2% to 5.7% of aggregate consumption. A loss we'd rather avoid.