This paper investigates the optimal education subsidy in an intergenerational model where both consumption and human capital externalities are present. Agents derive utility directly from their
children’s education as well as from leaving bequests, apart from choosing their own consumption level. In this framework, the government decides the optimal tax rates that maximize social welfare. This paper critically examines the effects of externalities on optimal education subsidy
and shows that what adjustment is needed to “internalize” the externalities. We find that the degree of externalities can be an important factor while deriving the optimal education subsidy level. It is shown that the relationship between the optimal education subsidy and the degree of
externalities depends on the effect of some important elasticities with respect to the education subsidy and the combined gain from the education subsidy adjustment.
Keywords : Educational subsidy, Optimal tax rates, Externalities