4/9/95
Paper presented at National Bureau of Employement, Education and Training/Australian National University Education conference, Canberra.
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In this paper, the case for educational investment is reassessed in the light of recent developments in economic theory and the results of empirical studies. Human capital theory, that is, the view that education may be regarded as a form of investment, is compared to its competitors and shown to be clearly superior. Empirical and theoretical evidence for the effects of education on economic growth is assessed. The microeconomic implications of human capital theory and the associated case for educational investment is developed. Finally, education policy is assessed in the light of national economic policy issues including unemployment and the national savings debate.
Introduction
Official and public enthusiasm for education has exhibited a cyclical pattern. First, substantial areas of inadequate funding are identified, and arguments are developed concerning the social costs of inadequate education, leading to increases in funding, either across the board or in selected areas. Then, disillusionment sets in as the more optimistic projections of the advocates of education spending are seen not to be fulfilled. A period of neglect and increasing financial stringency follows until the cycle begins again.
The sixties were a period of enthusiasm for education. In economics, the development of human capital gave theoretical rigor to the idea that education is an investment in the future. Early estimates suggested rates of return to education far higher than those available from investment in physical capital. Australia shared in the general enthusiasm for education. Expenditure on education was increased massively udner the Whitlam government. Some of the Whitlam government initiatives, most notably the decision to make university education free (despite the fact that university places were rationed) were ill-judged or premature. Nevertheless, the general infusion of resources under Whitlam was a rational response to the findings of the human capital research program.
The poor economic performance of the 70s and 80s led to a reaction against the economic policies of the past, including educational investment. An odd combination of radical left critiques of education (transmuted into 'screening theory') and radical right critiques of bureaucracy made public education a prime target for spending cuts. The human capital rationale for education The reaction was accentuated by the poor performance of the US school system in this period. In Australia, the response was to cut back on educational spending as a share of GDP, eventually to the level that prevailed before the Whitlam expansion. However, demographic trends meant that the proportion of school-age children in the population declined. This permitted a gradual increase in real resources per student until the late eighties.
Over the last ten years, however, the desirability of educational investment has been reaffirmed, most notably by theoretical and empirical developments in the analysis of economic growth. Both 'new growth theory' models and statistical analyses support the idea that education plays a crucial role in economic and social development.
Unfortunately, policy in Australia has not caught up with these developments. The dominant set of ideas, which I have referred to elsewhere as 'economic fundamentalism' combines hostility to all forms of public sector activity with a mercantilist bias in favor of traded goods, particularly exports of commodities and manufactures. It is, therefore, inimical to a rational assessment of education policy in the light of mainstream economic theory. Instead, recent education policy in Australia has been dominated by screening and public choice theories which are justified more by their capacity to yield the desired policy prescriptions than by any empirical evidence.
In this paper, the case for educational investment is reassessed in the light of recent developments in economic theory and the results of empirical studies. Human capital theory is compared to its competitors and shown to be clearly superior. Empirical and theoretical evidence for the effects of education on economic growth is assessed. The microeconomic implications of human capital theory and the associated case for educational investment is developed. Finally, education policy is assessed in the light of national economic policy issues including unemployment and the national savings debate.
Economic models of education
There are a number of economic models of school systems, with different interpretations of the functions of the system and hence different implications for policy. The four main models of education are human capital models, screening models, public choice/bureaucratic models and consumption models. As is argued at length in Quiggin (1995), only the human capital model has any serious empirical basis.
1 Human capital models
The human capital model (Mincer 1958, Schultz 1961, Becker 1964) is dominant in economic studies of education, and is employed in hundreds of journal articles every year. The human capital model is an elaboration, using the economic terminology normally applied to production of physical goods, of the commonsense notion that the function of schools is to teach students, that is, to provide them with information and skills that will be valuable in later life. Although the metaphor 'human capital' may appear shocking (and was probably chosen with an element of shock value in mind), the same metaphor appears, for example, in the title of this paper, with its reference to investment in education. As with other investments, a sacrifice of current income (the goods and services that teachers and students could produce if they were not engaged in education) is accepted in order to generate monetary and non-monetary returns in the future.
The human capital model is often linked with 'vocational' models of education, but the connection is spurious. The human capital model involves no particular assumptions about the relative market value of vocational training and general education, or about the relative importance of marketable skills and non-market cultural and social capacities. A knowledge of, and capacity to appreciate, literature, for example, may be interpreted as providing a future consumption stream not reflected in market earnings. To put the point in somewhat ponderous economic jargon, human capital acquired in education may be applied to household production as well as to market production. Thus, the human capital model does not, in itself, imply that education should be exclusively, or even primarily, vocational in nature, or that education should be valued exclusively in terms of monetary rates of return. However, the greater ease of measuring monetary returns has meant that most empirical studies have focused on monetary returns rather than on broader notions of education.
One nonmarket benefit of education that can be measured is the effect on health status and life expectancy. Cross-country analysis of life expectancy (Dowrick, Dunlop and Quiggin 1995) reveals that life expectancy is largely determined by the annual average consumption of food, health services and education. (For the wealthy countries, the influence of differences in food consumption is minimal.) Indeed, analysis shows that, for many countries, increases in education expenditure would be a more cost-effective method of increasing life expectancy than would increases in health expenditure. A similar result is revealed by studies of individual health status in the US and other wealthy countries. Education has a positive effect on health status, independent of any correlation between education and income levels (Grossman 1976, Kenkel 1990).
2 Screening models
The screening model may also be seen as the elaboration of a commonsense idea, namely the view that education consists of little more than jumping through elaborate hoops in order to obtain a meal-ticket. More formally, it may be stated that in screening models of education (Arrow 1973, Stiglitz 1975, Wiles 1974), it is assumed that education is of no inherent social value. Rather, the education system provides a method of sorting students and placing the most able individuals in the most difficult (and best remunerated) jobs. Although this ranking may be of some value, screening models suggest that we are spending too much on education. Indeed, given the innovations in IQ and other tests over the past forty years, which yield quite good predictions of educational performance, screening models would suggest that average levels of education should be falling, not rising.
The continued persistence of screening models in the literature is testimony to the impossibility of killing a superficially plausible theory, even in the face of repeated refutation. An extensive study of the literature, reported in more detail in Quiggin (1995), yielded not a single well-corroborated fact supporting screening models against the human capital alternative. Advocates of human capital models have repeatedly pointed out cases where the screening model predicts outcomes that are not observed in reality (for example, people who expect to become self-employed should not seek education, and the impact of education on wages should dissipate after a few years in the workforce). Screening theorists have responded by modifying their models to the point where their predictions coincide with those of human capital theory, or by complicating them to the point where they defy any possibility of testing and, therefore, of refutation.
3 The public choice/bureaucratic model
In public choice models, it is normally assumed that the managers of public institutions, such as educational institutions will seek to maximise their own utility and will promote the stated ends of those institutions only to the extent that it is personally beneficial to them. The public choice model of bureaucracy is developed in detail by Niskanen (1971). Niskanen argues that bureaucrats will benefit from expansion of their institutions beyond the socially optimal level. In discussions of education it is frequently assumed that effective control rests with teacher unions and that unions will seek to maximise the pay, conditions and numbers of teachers.
A variant of the public choice theory has dominated recent economic assessments of education in Australia. Although Niskanen's model implies that the output of the bureaucracy will be inefficiently high and the returns to members of the bureaucracy above the socially optimal level, he assumes that production is technically efficient. By contrast, the Australian model is based on the assumption that additional inputs have zero marginal effect on output. The Institute for Public Affairs (IPA) says, in an influential report (IPA 1990) prepared for the Economic Planning Advisory Council (EPAC), that its analysis is based on an a priori 'presumption that ... high staffing ratios do not provide a better quality of service'. This presumption is claimed to be derived from public choice theory.
IPA does not state how their assumption is derived from public choice theory and in fact it appears to have no theoretical basis at all. Obviously, the IPA assumption cannot be true for all possible staffing ratios or it would imply that one teacher could satisfactorily teach a thousand students. So there must be some 'cut-off' ratio beyond which the IPA assumption does not apply. In practice, the IPA implicitly defines the cut-off ratio as the lowest staff-student ratio prevailing anywhere in Australia, and argues for 'levelling-down' to this minimum ratio. But no basis at all is presented for choosing this level rather than a higher or a lower one.
The main set of empirical evidence that might appear to support the public choice model is derived from studies of the US in the late sixties and seventies, most of which adopted the 'educational production functions', in which education is modelled as a process using inputs such as teacher-hours per student and expenditure per student, and producing outputs measured by test scores. In general these studies failed to find any statistically significant correlation between test scores and school characteristics, including expenditure per student (Hanushek 1979, 1986). As argued in Quiggin (1995), these negative results may be explained by the observation that the performance of the US educational system in this period was anomalous in general. Although spending per student maintained its previous upward trend, outcomes, measured by test scores and completion rates stagnated or deteriorated. This pattern is quite different from experience in other countries or in the US prior to 1970.
The fact that quality mattered in the US prior to 1970 has been confirmed by a sophisticated study undertaken by Card and Krueger (1992). Card and Krueger use a 5 per cent sample of the US Census made available for public use and examine white men educated in US public schools between 1920 and 1949, divided into three ten-year cohorts. This is combined with extensive state-level data on the quality of education in those decades. Measures of school quality include length of the school year, teacher-student ratios and relative wages of teachers. Card and Krueger estimate the return to education for students in each state and cohort, and examine the relationship between the rate of return and school quality. They find that each of their quality measures is strongly, and statistically significantly, correlated with returns to education. Similar results were obtained by Wachtel (1976) and Rizzuto and Wachtel (1980).
Subsequent writers such as Fitzgerald (1993) have adopted the results of the IPA study without describing the underlying assumptions and citing EPAC rather than the openly partisan IPA as the source. For example, Fitzgerald's widely quoted estimate that spending on health and education could be cut by $3 billion/year without adverse consequences has no basis beyond the argument-by-assumption described above. Moreover the assumptions of the IPA have guided the budget-cutting activities of the Victorian and South Australian Commissions of Audit.
To summarise, the public choice/bureaucratic model, as it has been applied in Australia appears primarily to be an ex post rationalisation of a policy of expenditure cuts rather than a theoretically coherent analysis of education.
4 Consumption models
An alternative view of education is that it provides immediate consumption benefits (MacMahon 1987). The basic idea is that the experience of school may be valued for things (friendships, the excitement of learning) that are not particularly durable. Although consumption benefits of education are frequently regarded as inherently trivial, there is no economic justification for this. The happiness of a child today is just as important (more so, if discounting is taken into account), as the happiness derived by the same person as an adult with higher earning capacity and therefore higher consumption levels.
It is necessary to remember that education is an alternative to labour force participation. This has two important implications. First, since work provides consumption benefits for many people (workplace socialisation, the satisfaction of a job well-done, being treated as an adult), it is necessary to assess any consumption benefits of education relative to those that would be obtained from labour force participation.
More importantly, the main observable consequence of changes in the consumption benefits provided by education will be increased participation in education. Since, on most human capital views, higher participation rates are desirable, and since investment benefits of education will also be reflected in higher participation, it is very difficult to separate investment and consumption models of education. Sander and Schaeffer (1991) found that the main benefit of increased educational expenditure in the inner-city areas they studied was in increasing participation rates, which led to better job market performance.
Microeconomic implications of human capital theory
The primary policy implication of the human capital model is that society should invest in education up to the point where the returns are equal to those from alternative investments (for example, preservation of natural resources or the construction of physical infrastructure such as roads and hospitals). Since the great majority of studies shows that returns to education (even when defined narrowly to encompass only increases in earnings) are well in excess of the returns to alternative investment, the human capital implies that further expansion of spending on education and in the average educational attainments of individual students is socially desirable.
Focusing for the moment on market outcomes, education is viewed as an investment process in which short-term opportunities to earn income are foregone in order to increase long term earnings. This may be illustrated in Figure 1
Figure 1 Earnings curves - human capital model
In Figure 1, the two curves represent the earnings of individuals over their working lifetimes. In the low education curve, the individual leaves school and commences earning income at an earlier age. Earnings rise with experience, but at a slow rate. The relationship between earnings and experience eventually flattens out. There is also a relatively high probability that employment will be interrupted by spells of unemployment represented by the dotted section of the curve. The high education curve represents the earnings of an individual with similar skills who stays in education longer. This means a longer period without earnings and may also result in a starting salary below that of a contemporary who left school earlier and has more work experience. However, the more educated worker quickly overtakes her less-educated counterpart and this gap continues to widen over their working lifetime.
Since the less-educated individual earns more when young, it cannot be said unambiguously that the more-educated individual is better off. This depends on the time spent in education, the rate of increase of earnings and also on the rate at which future earnings are discounted. Empirical studies in the human capital framework seek to address these issues (see for example Blaug 1992, Psachoropoulos 1973, 1981, 1987) .
Trends in education over time
The human capital model implies that the level of investment in education should rise over time for two main reasons. First, improvements in technology typically act to reduce the demand for less skilled labour and to increase the demand for more skilled labour. Steam engines and later electric motors have wiped out most jobs based on the direct application of human and animal muscle power, but have created new jobs for engineers and technicians. Even comparatively unskilled jobs like those of plant operators require a much higher basic level of education (for example, the literacy required to read operating instructions) than those of the manual labourers displaced by machinery. This process is by no means uniform. Some highly skilled manual jobs (for example typesetting) have been eliminated by technological developments, and others have been 'deskilled'. However the basic pattern is clear.
The increasing demand for skilled labour implies that the benefits of increased educational attainment are greater than in the past. They also imply that opportunities foregone by students continuing in education are smaller. In boom conditions it is the first of these facts that is evident in high returns to educated workers. In recessions, the most evident fact is the very high rates of unemployment among poorly educated workers. However, the general tendency is always evident.
The other reason for a tendency to higher education levels relates to the nonmarket aspects of education, such as cultural and scientific knowledge and increased opportunities for self-awareness. These are what are referred to by economists as superior goods (or equivalently by Maslow as being high in the hierarchy of needs). What this means is that income rises and basic needs for food and shelter are met, an increasing proportion of expenditure will be devoted to objectives of this kind, and this will imply an increasing demand for education.
Some labour market evidence
The contrasting experience of the US and Australia provides useful evidence on the benefits of education and on the tendency for the optimal level of education over time. In the US, where average educational attainments have been roughly stationary since 1970, premiums for educated workers have risen dramatically (Howell and Wolff 1991). The increase in the wage premium reflects the trend increase in demand for skilled workers and the decline in the demand for unskilled workers. The causes of the stagnation in US educational attainments, and the decline in performance in test scores, remain unresolved, but almost certainly reflect social failures both within and outside the school system. Among the consequences has been a massive increase in inequality and the phenomenon of the 'disappearing middle'. Roughly speaking, whereas the unionised working class of the fifties and sixties enjoyed more or less middle-class wages and conditions with firms like General Motors their children are struggling to find minimum wage jobs with MacDonalds.
The demand for skilled labour is rising relative to the demand for unskilled labour in Australia also. However, the differential return to high school and university education has actually fallen/ The explanation is simple. The normal theory of supply and demand implies that, other things being equal, the more skilled individuals there are, the lower will be the skill premium. In Australia, this the rapid increase in education levels for younger workers has kept pace with, and in some periods outpaced, the rising demand for skill.
However, there are worrying signs that a US-style inequality boom is about to emerge. Cutbacks in school funding, notably in Victoria, have halted the decade long increase in school completion rates. At the university level, a massive expansion in participation has been achieved with only minimal increases in real funding levels, implying substantial reductions in expenditure per student. The contradictions inherent in this process are beginning to become apparent.
Education and economic growth
Theories of economic growth fall into two main groups, often referred to as 'old growth theory' and 'new growth theory'. In broad terms, these approaches may be distinguished by saying that old growth theory sees education as important, while new growth theory sees education as critical.
The basic idea of old growth theory is that of capital accumulation. For a given population, the level of output will be determined by the stock of physical and human capital and by the state of technical progress. In these models, technical progress is taken as exogenous or given, so the focus is on the pattern of saving required to generate capital accumulation. Saving may take the form of directing output towards new machinery and buildings rather than towards current consumption. Alternatively, and more interestingly, it may take the form of putting resources into education. Obviously these resources include schools and teachers. More importantly, it includes the work of students who could otherwise be engaged in current production and receiving wages. In less developed countries, (and in wealthy countries with inadequate public finance of education), the biggest obstacle to expanding educational provision is the inability of students, or their families, to forgo potential earnings.
In old growth theory, education is just one form of capital accumulation. New growth theories , put education at centre stage by making technological progress endogenous, that is, dependent on the existing level of knowledge and skills (Stokey 1991, Glomm and Ravikumar1992, Tallman and Wang 1992, Hartwick 1992). Although the details vary, new growth models generally strengthen the view that education yields benefits to the entire community, going beyond the private returns to individual students.
Empirical studies of growth
Economists have used two main methods to analyse the determinants of economic growth. First, they have undertaken cross-country comparisons in an attempt to isolate those factors that are conducive to economic growth. A great many such factors have been suggested but the literature displays very few consistent results,w ith one important exception. A systematic study of such factors found that the great majority or proposed correlations (for example, between growth and inflation, or between growth and public spending) are not robust to changes in the specification of estimating equations (Levine and Renelt 1992, Levine and Zervos 1993). Almost the only policy-relevant causal relationship that has been identified is that the higher the proportion of school-age young people actually attending school at the beginning of any given period, the higher the growth rate over the subsequent period (Barro 1991, Woo 1991, Mankiw, Romer and Weil 1992). Thus, the cross-country evidence is strongly supportive of the view that education contributes positively and significantly to economic growth.
The second approach used by economists is referred to as 'growth accounting' and involves studying the performance of individual countries over time, attempting to apportion observed economic growth to factors such as growth in the labour force, investment in physical capital and increases in education levels (human capital). In early studies of US economic growth (Denison 1962), human capital investment was found to be substantially more important than physical investment. Later estimates have been more modest, btu still, in most cases, statistically and economically significant (Jorgenson and Fraumeni 1992).
The decline in the relative importance attributed to human capital has been used by some critics of human capital theory (eg Maglen 1990) to suggest that education is not after all, a sensible investment. However, this represents a misinterpretation of the evidence. In most countries, human capital investment is around 5-7 per cent of GDP and physical capital investment is around 25-30 per cent of GDP. Thus, it would be expected that the contribution to growth of physical investment would be about 4 to 5 times as great as that of physical investment. The results of Denison (1962) are plausible only if human capital investment was massively more productive than physical investment in the relevant period. It is therefore unsurprising and not in the least disturbing to find that other estimates give a smaller, but still very important role to human capital investment.
Education and inequality
First, there is an obvious and direct stimulus to equality if public financing is used to open educational opportunities to groups were previously unable to afford it. In this case, we would expect that variability in education levels would decline significantly. The development of public education systems in the 19th Century had this effect, and similar effects arise from the provision of universal education in less developed countires (Lam and Levison 1991). However, subsequent expansion of educational expenditure has increased the average number of years of education but has not reduced the variance, and may even have increased it. Much of the disappointment in expectations for education-driven equality have arisen from a failure to appreciate this point.
It is possible that further expansion of education may lead to a decline in the variance of attainments. Participation in post-graduate education seems likely to remain low. Hence variance in attainment might well be reduced by the achievement of a situation where post-secondary education was the norm.
Even if the variance of educational attainment is unchanged, expansion of education may be expected to promote equality in another way. As the human capital metaphor suggests, income arises either from the exercise of effort and skill or from the ownership of physical capital. The ownership of physical capital is very unequally distributed. The larger is the average endowment of human capital, the less important is inequality in ownership of physical capital. This argument is weakened, but not fatally so, by the observation of a moderate positive correlation between wealth and education levels.
The equalising effects of education must be analysed in combination with other processes at work in society. There are important forces at work tending to promote an increase in social inequality. The most important are the inheritance of wealth and the continuing tendency of technological change to reduce the demand for less-skilled labour. A process of continually increasing the base level of education offsets the tendency to inequality that would otherwise arise from these processes. To put it another way, we need to keep running just to stand still.
Education and national economic policy
National savings
The debate over public expenditure in Australia is closely linked to concerns about national savings. This concern was crystallised by the publication of the Fitzgerald Report (1993), on the cover of which was presented a chart showing alarming declines in national savings and particularly in public savings. Fitzgerald also includes a chart (Chart 5.2) showing that when 'human capital' expenditures (on education, health and R&D) are taken into account, public sector saving has remained broadly constant over the past 30 years and reached near-record levels in the late 1980s. The sharp deterioration in public sector savings of the mid-70s disappears, since the Whitlam governments increased spending on education and health is reclassified as investment instead of consumption. Similarly results are obtained by Depta, Harding and Ravalli (1994) who attempted a more careful breakdown of health expenditure into consumption and investment components. However, Chart 5.2 is presented in the context of a discussion of the impact of public saving on private saving. It is not referred to in relation to the conclusion that public sector savings should be increased, nor does it inform the analysis of appropriate changes in public expenditure.
In reading the debate over national savings, it is difficult to avoid the conclusion that human capital measures are often rejected, not on theoretical grounds, but because they might upset predetermined policy conclusions. For example, Cox (1994) argues for policy changes based on the measured decline in public sector savings. He observes (p 27) that human capital theory implies that education spending and much health spending should be classed as investment, but rejects this suggestion on the grounds that 'as such spending has risen rapidly, to do this would be to redefine into non-existence much of the government (and national) savings problem.' In other words, the validity of the measure is determined by its capacity to give the desired answer.
5 Unemployment
The debate between human capital and alternative views is also highly relevant to the problem of unemployment. The relatively low priority accorded to unemployment by economic policy-makers implies a lack of concern with the processes of human capital formation which contrasts notably with the central role accorded to physical investment in discussions of economic policy.
Moreover, activities such as education and health care are highly labour and human-capital intensive. If the problem of unemployment is viewed more generally as one of declining demand for labour in general and unskilled labour in particular, the optimal policy response is both to raise the average level of human capital and to increase the output share of labour- and human capital- intensive activities. As is argued in Langmore and Quiggin (1994) an expansion of these activities could lead to a substantial increase in employment for any given level of economic activity.
Opposition to policies of this kind reflects, in large measure, a pre-human capital view of the world in which the central issue is the production of goods by the mining, agriculture and manufacturing sectors. Services such as health and education are seen as a cost burden and an obstacle to competitiveness.
Concluding comments
The economic evidence consistently supports the view that investment in education yields monetary returns as high as, or higher than, those of investment in physical capital. Since education also has substantial cultural and social benefits that cannot easily be assessed in monetary terms, the conclusion that more investment in education is socially desirable is a compelling one.
Governments, driven by short-run fiscal stringency and an ideological focus on the size of the public sector, have, since the middle seventies, sought to constrain and even reduce spending on education. As a result, the progress that has been made in educational provision and educational attainment over the past twenty years has been almost exclusively dependent on the policy initiatives of the Whitlam era, a period when education was consistently viewed by both the electorate and government as one of the most important concerns of policy. Further progress in educational achievement requires a renewed willingness to finance investment in education.
References
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