A Libertarian Perspective on Economic and Social Policy

Lecture 3

Subsidizing Education

©2007 Jeffrey A. Miron

Introduction

• Government intervention in the market for education is widespread:– Public schools (K-12)– State colleges and universities– Tuition subsidies, grants, loans for higher education– Research funding for higher education

• Compulsory Education Laws• Regulation of Public Schools

– Required curriculums– Teacher certification rules– High-stakes testing

Introduction, continued

• There is widespread support for most or all of this intervention;– Indeed, voters and politicians of all

persuasions often talk as though more government expenditure on education is always desirable.

– Liberals and conservatives differ on how to spend this money; but both sides accept the wisdom of an enormous role for government in the market for education.

Introduction, continued

• This is first of two lectures that will examine the merits of government intervention in the market for education.– Today’s lecture considers the basic question of

whether government should subsidize education; that is, should it undertake policies that increase the overall amount of education acquired.

– A second lecture will examine the regulation of K-12, taking as given the existence of public schools. The question will be whether policies like charter schools, vouchers, high-stakes testing, teacher certification, and related policies do more good than harm.

Outline

• Overview of Existing Subsidies

• Standard Arguments for Government Subsidy

• Evaluation of the Standard Arguments

• Should Government Subsidize versus How Should Government Subsidize?– The case against government schools.

Overview of Current Subsidy for Education in U.S., 2004

• Primary and Secondary Expenditure– $475.5 billion.

• Higher Education Expenditure– $200.1 billion

• So, the magnitude of government intervention is substantial.

Given this intervention, there are two obvious and related questions:

• Why does government need to intervene in the market for education?– That is, doesn’t the market lead to the “right”

amount of education?

• If the market outcome is not right, what is the best way to intervene?

• To answer these questions, we first need to consider the basic model of education.

Human Capital:The Economic Model of Education

• Every person in society has a certain amount of brain power, skill, knowledge, understanding, and the like:– All those factors other than your “unskilled”

labor that allow you to produce output.

• We can think of all these factors as one, composite factor: – Human Capital

Human Capital, continued

• Useful to think of human capital as analogous to physical capital– Durable; continues to have value over time;– Can decrease over time due to “depreciation”– Can increase due to “investments”

• Acquiring education is like making a physical investment: improves the quantity and/or quality of your human capital.

• The purpose is to increase productivity.

Return to Education

• The analogy to physical capital suggests thinking about “investments” in education as producing a “return”: – This return is the extra productivity one

receives as the result of more education.

• Typically calculated as the percentage increase in annual income resulting from an additional year of education, for example a number like 7%.

Determining the Amount of Education

• The basic assumption of the human capital model – that education increases one’s productivity – makes sense.

• The question is then, how much education should one acquire?

• If acquiring education has no costs, then the answer is obvious: infinity.

• But acquiring education does have costs, so we have to think about trading off the costs of education versus the return it generates.

The Costs of Investments in Education

• Explicit costs like tuition, fees, transportation, uniforms, textbooks.

• Opportunity cost: the value of the time spent obtaining education.

• Any disutility of this time relative to the utility/disutility of the alternative activity.– If education is “fun,” can think of this as a

negative cost, i.e., a benefit.

How much Education Should each Person Get?

• Not necessarily the same amount or kind:– Different people have different costs of

obtaining education– Different people have different benefits of

obtaining education

• Each person should use the same rule, however:– Keep getting more education up to the point

where the marginal benefit (increased productivity) equals the marginal cost.

Education Versus “Dishwashers”

• Described in this way, the decision about how much human capital to acquire sounds exactly like a decision about how much physical capital to acquire.

• You should buy a dishwasher if the return (saved time) exceeds the cost.– If you hate washing by hand, more likely to get a dishwasher.– If you like washing dishes, the opposite.

• But there’s no obvious reason why individuals can’t decide for themselves whether to buy a dishwasher.

• And no obvious reason for government to subsidize.– The durability of investments in education is irrelevant.

So Why Should Governments Subsidize Education?

• Three possible justifications:– The social return to education exceeds the

private return (spillovers)– The social return equals the private return, but

some people are myopic and therefore underinvest in education

– Independent of the social versus private return, some people are too poor to purchase education; moreover, they cannot borrow because of credit constraints.

The Spillover Argument for Subsidizing Education

• Some types of education might improve not only one’s own productivity but the productivity of others in society:– Reading and writing a common language– Sharing basic math skills– Sharing knowledge of, or respect for, common laws,

history, culture, business practices, …• Thus, the return to the person acquiring the

education might be less than the total return to society.

• Stated differently, education might generate positive externalities.

The Social versus Private Return to Education

• The notion that education generates positive externalities is plausible– Aside: we should be suspicious of this

argument coming from academics, since they are the ones who benefit.

• Nevertheless, it is important to recognize the limits of this argument.

Social Versus Private Return:Limitations to the Argument

• The existence of an externality does not imply an arbitrarily large subsidy:– The standard analysis says subsidize to the point where

Marginal Social Benefit equals Marginal Social Cost.– This is a finite amount.

• Some kinds of education seem unlikely to generate externalities:– Shakespeare? Computer Science? Auto Mechanics?

• The externality is difficult to measure:– This does not mean it is zero, but …

• The externality argument is often “in the eye of the beholder.”– Humanities versus Sciences versus Economics?

• Existing estimates do not suggest large spillovers.

The Spillover Argument for Subsidizing Education: Summary

• There probably are positive spillovers from education.

• But neither a priori reasoning nor existing evidence suggests a large effect.

• To the extent spillovers exists, it seems plausible they are most relevant for teaching the Three R’s to young children, not for helping 20 years olds study medieval literature.

The Myopia/Paternalism Argument for Subsidizing Education

• Some individuals might underinvest in their own education because they are too myopic to recognize the benefits.– Similarly, some parents might underinvest in their

childrens’ education.

• In the case of adults, subsidizing education can reduce the impact of the myopia, potentially increasing the welfare of the adult.

• In the case of children, subsidizing education can overcome the failure of parents to invest sufficiently in their children.

Evaluation of the Myopia Argument for Adults

• Are some adults myopic?– Yes.

• Does paternalism increase the welfare of myopics?– That depends on a number of factors.

• Interventions based on this argument can adversely affect the non-myopic.– For example, compelling too much schooling.

• Interventions based on this argument open a Pandora’s box of government thought control.

Evaluation of the Myopia Argument for Children

• Do some parents make bad choices for their children?– Yes

• Do many parents make sensible decisions most of the time and make substantial sacrifices for their children?– Yes

• Can parents make an enormous range of bad choices for their children:– Yes. For example, too much TV, not enough homework,

excessive focus on sports, …., bad parenting generally.

• So does promoting reasonable choices with respect to education increase the welfare of children overall?– It’s hard to know. And going down this path again opens the

Pandora’s box of possible government control over parenting.

Evaluation of the Myopia Argument for Children, continued

• Even if one takes as given that policy should subsidize education to help children, note that– This is more likely an issue for young children

and initial levels of education than for, say, a fifteen or twenty year old.

– This argument again does not suggest arbitrarily high subsidies; it says merely that the optimum level of subsidy is positive.

The Credit Constraint Argument for Subsidizing Education

• Some persons for whom education would be a productive investment do not have funds to pay for tuition or to pay living expenses while in school.

• The absence of “self-financing” does not by itself explain low investment in education, however.

• Continuing the analogy to physical capital, persons who have productive educational opportunities but not self-financing can borrow and repay the loans out of future income.

• So, one needs an additional assumption to justify intervention:– Credit Constraints

Credit Constraints

• What is a credit constraint?– Roughly, a situation in which a potential

borrower cannot obtain a loan even though the expected PDV of the investment is positive.

• The fact that some investments are risky (i.e., might default) does not by itself explain credit constraints:– Merely implies high interest rates.

Credit Constraints, continued

• So why do not banks lend to finance investments in human capital, even though they routinely finance investments in physical capital?

• To some extent, they do.• To the extent they do not, presumably because

of two features of human capital – Unobserved heterogeneity in the probability of default– Non-collateralizability of the loans.

Unobserved Heterogeneity andAdverse Selection in Loan Markets

• Consider the following assumptions:– Individual borrowers have varying probabilities of

defaulting on an education loan.– And, individual borrowers know their own “type.”– Potential lenders cannot tell who is a good risk and

who is a bad risk.– If the lender sets an interest rate consistent with the

“average risk,” only the bad risks borrow, and the lender goes broke.

• This is an example of a classic problem in economic settings with asymmetric information– Adverse selection.

The Adverse Selection Hypothesis, continued

• An important assumption underlying this model is that there is no collateral backing up these loans.– If there were (think of a mortgage loan), then default

is not such a big deal– The bank just repossesses the collateral.

• In the case of loans for education, collateral is somewhat problematic:– The loan agreement could specify that the borrower

must repay out of future income.– But awkward to enforce in practice.

The Credit Constraint Argument for Subsidizing Education

• So, the basic credit constraints hypothesis is plausible, as far as it goes.

• But, it is potentially overstated.– Banks have some ability to determine good

risks and bad risks.– Banks can impose collateral requirements in

many instances.

The Credit Constraint Argument, continued

• Plus, there are various mechanisms that diminish the impact of credit constraints– People can make investments incrementally– People can apprentice

• The existing evidence suggests credit constraints do deter some education, but not an enormous amount.

• And, as with spillovers and myopia, this argument applies more readily to the very young and to initial levels of education.

• This argument also applies more forcefully to low-income households.

Summary So Far

• The standard economic arguments potentially justify some degree of subsidy for education– Difficult to determine how much.– Amount likely smaller than most people think.

• Arguments so far also suggest that subsidy makes more sense at, say, the K-6 level than, say, the college level

• And, the arguments suggest that the subsidy should go to low-income households rather than all households.

Does All This Mean Subsidizing Education is Desirable?

• By itself, no. Assuming these arguments are valid empirically, they show there is potentially some benefit from subsidizing education.

• But to justify a deviation from laissez-faire, we need to know that benefits of the intervention exceed its costs.

• And subsidizing education potentially has large costs.

The Costs of Subsidizing Education

• Deadweight Loss from taxation.• Government must decide what constitutes

education.• This creates the potential for thought control.• This promotes standardization• This discourages innovation• This forces government to take a stand on

messy issues such as speech codes, affirmative action, single-sex education, and more.

Bottom Line on Whether to Subsidize Education

• Reasonable people can certainly support subsidies for education.

• But reasonable people can also argue the optimal subsidy is zero:– Laissez-faire equilibrium closer to the efficient

outcome than usually acknowledged– Costs of subsidizing potentially far in excess of any

benefits.• If there’s a subsidy, should be mainly aimed at

early years.• If there’s a subsidy, should be mainly aimed at

low-income households.

Assuming Government Should Subsidize Education, How?

• As noted, many kinds of subsidies exist currently:– Government owned and operated schools

• K-12• State colleges and universities

– Subsidized loans– Grants, scholarships

Nothing in the Subsidy Argument Requires Government Schools

• The problem, to the extent one exists, consists of underinvestment in education

• There is no reason to suspect any market failure in producing education:– Lots of private schools exist.– Optimal scale is plausibly small.– Looks like a reasonably competitive market.

• Thus, a policy that lowers the price is sufficient.

Standard Approach to Reducing the Price is Vouchers

• The parent of each school-age child receives a piece of paper that the parent can use to purchase private educational services.

• Private schools accept vouchers as payment because a public or private entity promises to redeem the vouchers for money.

Vouchers, continued

• The voucher amount need not equal the entire cost of the educational services.

• The price of a year of education at some or all schools might exceed the voucher amount.

• For example, say cost of a “basic” education is $5,000.

• Then the voucher might be for $5,000. Some schools would charge more, and some parents would pay the extra out of private funds.

Is the Voucher Approach Better than Government Schools?

• Vouchers are readily means-tested, which is consistent with analysis above.

• Under vouchers, private schools have an incentive to innovate, control costs, oppose bad regulation.

• Under vouchers, it is easier, although not trivial, to address controversial issues:– Single sex schools– Speech codes– Controversial faculty– Affirmative action

Vouchers versus Public Schools, continued

• BUT: The voucher approach has its own risks:– It puts the government in the position of defining ALL

schools, which potentially gives it more control and ability to suppress competition, impose bad regulation, stifle innovation, and the like than under the current system that at least has some competition between private schools and between the public and private systems.

• So, some libertarians believe vouchers are worse than the status quo.

Final Point on Vouchers

• A distinct question from whether vouchers are better than public schools, or better than the current system, is whether they will produce a dramatic increase in the quality of education.– Many advocates believe the answer is yes.

• My assessment is more nuanced:– Vouchers will improve quality a little (e.g., 5%)– Vouchers will reduce costs a lot (25-50%?)– Vouchers will increase satisfaction a lot.

• So, vouchers are a plus, but they won’t turn us into a nation of geniuses.

Conclusions

• The case for subsidizing education is far weaker than usually assumed and in my view suggests at most limited intervention:– Means-tested vouchers for, say, K-6.

• There is a strong case against government schools as a method for subsidizing education, even if a subsidy makes sense:– Any intervention that is warranted can be

accomplished with means-tested vouchers.