Micro and macro data suggest that the distribution of resources among families affects children'’s future earnings abilities. As a result, an optimal tax policy will treat future ability distributions as endogenous. In this paper, we analytically characterize how making children'’s abilities a function of parental resources affects optimal tax policy. We also numerically simulate optimal policy in this setting, using evidence on the distribution and heritability of natural abilities and the elasticity of children’'s ability with respect to parental resources to parameterize the model. Preliminary results show that optimal policy raises the earnings abilities of all children relative to a policy that neglects the endogeneity of ability, and that the welfare gains from optimal policy are substantial. Harvard Business School Working Paper No. 13-014
, also NBER Working Paper #18332.