Insuring Educational Risk: Opportunities versus Income

Abstract

We develop a model of education where individuals face educational risk. Successfully entering the skilled labor sector depends on individual effort in education and public resources, but educational risk still causes (income) inequality. We show that an optimal public policy consists of deferred skill-specific tuition fees, lump-sum transfers/taxes, and public funding of the educational sector. We argue that improved educational opportunities matter more than direct income transfers in a Second-best setting. Contrary to standard models of income risk, it is not optimal to use a proportional wage tax, because combining skill-specific tuition fees and public education spending provide both insurance and redistribution at lower costs. A wage tax is only optimal if skill-specific tuition fees are not available.

Full text

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Insuring Educational Risk:
Opportunities versus Income



DIRK SCHINDLER
BENJAMIN WEIGERT


CESIFO WORKING PAPER NO. 2348
CATEGORY 1: PUBLIC FINANCE
JULY 2008






An electronic version of the paper may be downloaded
• from the SSRN website: www.SSRN.com
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CESifo Working Paper No. 2348



Insuring Educational Risk:
Opportunities versus Income


Abstract

We develop a model of education where individuals face educational risk. Successfully
entering the skilled labor sector depends on individual effort in education and public
resources, but educational risk still causes (income) inequality. We show that an optimal
public policy consists of deferred skill-specific tuition fees, lump-sum transfers/taxes, and
public funding of the educational sector. We argue that improved educational opportunities
matter more than direct income transfers in a Second-best setting. Contrary to standard
models of income risk, it is not optimal to use a proportional wage tax, because combining
skill-specific tuition fees and public education spending provide both insurance and
redistribution at lower costs. A wage tax is only optimal if skill-specific tuition fees are not
available.
JEL Code: H21, I2, J2.
Keywords: human capital investment, endogenous risk, learning effort, optimal taxation,
public education.




Dirk Schindler
University of Konstanz
Fach D 133
78457 Konstanz
Germany
Dirk.Schindler@uni-konstanz.de
Benjamin Weigert
Justus-Liebig-University of Gießen
Department of Economics
Licher Strasse 66
Germany – 35394 Gießen
benjamin.weigert@wirtschaft.uni-giessen.de


June 24, 2008
We are indebted to Alexander Haupt, Bas Jacobs, Leo Kaas, Tim Lohse, Normann Lorenz,
Christian Lumpe, Agnar Sandmo, Guttorm Schjelderup and Stefan Zink as well as
participants of seminars and conferences in Gießen, Warwick, Oslo, München, Konstanz,
Garmisch-Partenkirchen and Gent for valuable comments. The usual disclaimer applies. An
older version of this paper has been called “Educational Risk and Public Policy: Taxation,
Fees, Loans, and Incentives.”

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1Introduction
For more than 30 years, rising wage inequality, especially between incomes in
the skilled labor sector versus those in the unskilled one, is observed, see, i.e,
Krugman (1995) or Katz and Autor (1999). This type of inequality is also accom-
panied by income risk. The reason is that employment as skilled worker requires
both successful graduation in the higher education sector and finding a suitable
job later on. Both is by far not guaranteed, see, e.g., OECD (2007, Indicators A3
and A8). Accordingly, (educational) risk of failure to enter the skilled sector is a
salient feature of human capital investment and distributional inequality interacts
with income risk.
What happens then to those households, who fail and end up as unskilled,
and how can welfare of the unskilled workers be increased in an inequality-averse
society? Different approaches to this problem can be observed: in welfare poli-
cies the main focus is on redistribution via direct income transfers as, e.g., the
earned income tax credits in the USA. An additional strategy is to implement
minimum wages, which are in place, i.e, in the U.K. and in France. A more recent
political agenda is to foster educational opportunities, to decrease drop-out rates
(especially at schools) and to ensure that the major part of the population attends
higher education. This is part of the so-called renewed ‘Lisbon-agenda’ in the EU,
announced in 2005 as strategy for growth and jobs (EU-Council, 2005).
However, in the political debate, there seems to be no consensus on what the
best strategy is and the implementation of the ‘Lisbon educational offensive’ in
the EU member countries is doing poorly according to a EU press release in Oc-
tober 2007 (EU-Commission, 2007). Even more amazing – and to the best of our
knowledge – these topics have been entirely neglected in the economic literature,
although stylized facts strongly indicate that drop-out rates are non-negligible and
that higher education has enormous effects on the labor market perspectives of
households (OECD, 2007, Indicator A8). Consequently, the very important, but
still pending question is: Should the government redistribute ex ante by increasing
educational opportunities or ex post by means of income redistribution?
This paper shows that in a Second-best world, where learning effort cannot
be controlled by the government and collecting tax revenue induces distortions,
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it is more important to increase educational opportunities, measured as the suc-
cess probability to graduate, than to provide ex-post income insurance by direct
transfers from the skilled to the unskilled.
Thereto, it is not optimal to use distortionary wage taxation, if the govern-
ment can apply deferred skill-specific tuition fees. Educational opportunities are
enhanced by an improved resource endowment in the educational sector – which
simultaneously counteracts tax-induced negative incentive effects in learning ef-
fort. The combination of skill-specific tuition fees and public funding of the ed-
ucational sector simultaneously allows for redistribution and insurance at lower
costs compared to wage taxation and direct income transfers.
In short, the main intuition is: Collecting revenue in a Second-best world is
costly, but spending the revenue in the educational sector instead of granting in-
come transfers, ceteris paribus, mitigates distortions in learning effort and de-
creases the marginal costs of taxation, whereas both ways of spending decrease
income risks and increase welfare.
The main idea behind the outline of our models rests on (i) that wage inequal-
ity interacts with educational risk and (ii) that learning effort (how time is spent
at school respectively at university) and resource investment in the educational
sector endogenize the risk of failure to enter the skilled sector, opening another
channel for governmental policy.
The accelerating wage inequality since the 1980s is driven by globalization
and increasing international trade (Krugman, 1995) and – to the most part – by
skill-biased technological change (Katz and Autor, 1999). Both are seen as either
putting pressure on low-skilled wages and favoring skilled labor (the “American
way”)orcreatingunemploymentinthelow-skilledsector, iftherearelabormarket
rigidities (the “European way”). Jacobs (2004) supposes the wage differential to
increase even more in the future, due to the growth rate of skilled labor supply
lacking behind the demand for skilled workers – implying that wages can be even
less forecasted than by now.
As future wages can hardly be predicted, when investing in human capital,1
1See, e.g., Carneiro et al. (2003) showing for high-school and college graduates that the over-
whelming part of variance in returns to education cannot be predicted by students at the time of
making their investments.
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wage inequality and educational risk are intertwined. Consequently, educational
risk can be twofold (Levhari and Weiss, 1974; Kodde, 1986, 1988): the most
obvious is the risk to fail graduation, implying that most of the resources invested
might be lost. The other type of risk is the uncertainty about future wages and
employment opportunities.
Analytically, the cases of failed graduation and failed (well-payed) employ-
ment can be described in the very same way as uncertain future wages, if the
probability of failure is exogenous. However, to assume that this probability is
exogenous for individuals is not plausible. Therefore it appears reasonable that
to some degree the probability to graduate and to get a job as skilled worker is
the result of individual choices such as learning effort. Obviously, the effort cho-
sen by individuals will, amongst others, depend on the quality of the educational
system and on public resources spent on education.
Endogenizing learning effort then opens another channel, through which gov-
ernmental intervention both via public spending and tax revenue collection in-
fluences market outcome: On the one hand revenue collection can have negative
effects on learning efforts, increasing the risk of failure in education and with it
income risk. On the other hand, the government gains another insurance device in
increasing the success probability and providing ex ante insurance.
In order to analyze these topics, we apply a two-period model, where the indi-
viduals first decide on their learning effort. This decision determines their success
probability in higher education and in entering the skilled sector. Then risk real-
izes and the individuals choose their labor supply either as skilled workers or as
unskilled ones. The benevolent government can use a proportional wage tax and
a combination of tuition fees and skilled-contingent loans in order to finance both
a general lump-sum transfer and public funding of the education system. Public
educational spending is assumed to increase the success probability, because an
enhanced quality in the educational sector, e.g., an increased number of teachers
at university, improves the learning technology.
The proceeding is as follows. The next section contains a short overview on
related literature. In section 3, we present the model, and examine household
behavior in the fourth section. Section 5 then establishes the First-best alloca-
tion as benchmark case, whilst section 6 introduces public policy and section 7
3