Efficient progressive taxes and education subsidies
The optimal response of the government to this dilemma is to choose a system of progressive taxes and to (partly) subsidise investment in human capital.
A combination of generous education subsidies and steep tax rates is more likely to prevail the larger the power of trade unions to set wages, the better the ability of the government to steer private efforts to educate, and the higher the preference for equality between the employed and the unemployed.
An empirical analysis for several OECD countries gives similar results. A policy mix of high education subsidies and relatively progressive income taxes is found in countries where union membership is significant and the replacement rate is high.