The return to education

Something that is obvious to us all is that a good deal of the direct cost of education is in many countries subsidised by governments. The question is why. A standard answer to that question is that education generates external returns for society. A new column at VoxEU.org argues that there is in fact little evidence of such returns. If there are reasons to subsidise education, they don't include economic externalities.

Steven Yamarik begins his column, entitled What does state-level data tell us about the social value of education? by noting that

The most commonly-cited economic rationale for public investment in education is positive productivity spillovers from education. The individual student attends school in order to raise his or her earnings potential and possibly to directly increase his or her current utility. The increase in individual earnings due to educational attainment is called the private return to schooling. However, the knowledge gained by an individual can spread or "spillover" to others and thus increase aggregate productivity. The increase in income generated from the spillover is called the external return, while the sum of the private and external returns is the social return to schooling.

Since at least the work of James Heckman and Peter Klenow, one approach used to determine the size of the human capital externality is to compare the estimates of the private and social return to schooling. Yamarik explains,

Mincerian wage equations at different levels of aggregation can be used to estimate the two returns to schooling. At the microeconomic level, the Mincerian wage equation predicts that the log of earnings depends positively upon years of schooling, labour force experience, and experience squared. The coefficient in front of years of schooling is interpreted as the private return to schooling. At the macroeconomic level, the macro-Mincerian equation predicts that the log of aggregate income is positively related to physical capital, average years of schooling, and average labour force experience. By aggregating individual characteristics, the macro-Mincerian equation can capture externalities associated with schooling and thus provide estimates of the social return to schooling. Lastly, by including both individual and macroeconomic factors, the augmented micro-Mincerian equation can uniquely identify the private return to schooling and the external return to schooling. The sum of the two is the estimate for the social return to schooling.

Yamarik argues that data from the states of the US provide an opportune laboratory for testing for externalities in schooling. He notes three positives for the use of this data,

First, the educational structure and curriculum are more similar across US states than across countries. Second, state-level and individual schooling data are uniformly collected by the federal government. Third, US states share similar institutional and political backgrounds, while countries do not. As a result, state-level estimates of the return to schooling are less likely to suffer from bias introduced by measurement error, omitted variables, and parameter heterogeneity.

His summary of the results of recent work is,

Labour economists have estimated the micro-Mincerian wage equation using different time periods, samples, and econometric techniques. For the US, the private return to schooling ranges from 4% to 16% with a consensus estimate around 10%.

The recent construction of state-level physical and human capital stock data has provided the opportunity to apply the macro-Mincerian model to US states. Chad Turner and his co-authors estimated a social return of 12% to 15%, while I estimated a slightly lower social return of 9% to 13%. The closeness of the estimates of the social return to the private return suggests that US schooling generates little to no external return.

Researchers using the augmented micro-Mincerian equation find little evidence for the presence of external returns. These researchers match individual earnings and education data to city-level or state-level characteristics. An early study by James Rauch estimated an external return of 3% to 5%. However, more recent work by Daron Acemoglu and Joshua Angrist, Jeremy Rudd, Antonio Ciccone and Giovanni Peri, and Fabian Lange and Robert Topel find no statistically significant external return.

The conclusion that follows from this is not governments should automatically stop subsidising education but that the reasons for any subsidy must be the non-pecuniary externalities that can be generated from schooling. In Yamarik view there are three such externalities,

First, increased knowledge can make a person more interesting (and even more attractive) and thus raise the utility of others. Second, Lance Lochner and Enrico Moretti show that schooling reduces criminal activity and generates a substantial social effect. Third, Milton Friedman has argued that education enables individuals to participate more efficiently in the political process.