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Should daycare be subsidized

In the presence of distortionary taxes on labor, can subsidies on childcare, financed by a further increase in taxes, raise welfare by encouraging women with small children to work? We approach this question in two different ways. First we consider a set of stylized models where we prove analytically that under some conditions the Ramsey optimal policy consists in making childcare expenses tax deductible. Then we construct a calibrated stochastic dynamic life-cycle model of household decision-making designed to capture some facts about labor supply in Germany. We find that the welfare gains associated with subsidizing childcare are considerable, and that the maximum gains are realized when childcare is subsidized to an even greater extent than what tax deductibility implies.