The Impact of Education on Economic Growth Theory, Findings, and Policy Implications Brian G. Dahlin Duke University 2 I. Introduction In June of 2002, President Bush announced a doubling of funds for the African Education Initiative. Total U.S. spending on basic education in Africa will total $630 million over the next five years. Motivation for such an increase lies in the belief that the education of children in developing countries “is key to future economic growth and lasting democracy, leading to greater stability and improved standards of living.” 1 Many growth models include education and offer predictions as to the implications of education policy changes on macroeconomic performance. Some empirical analyses of the growth rate of real per capita GDP in the U.S. suggest that years of secondary and higher schooling contribute positively toward economic growth. 2 Such research is of particular importance as developed nations continue taking a more active role in the development of third-world nations, as growth models offer predictions useful in aiding policy decisions. 1 Office of the Press Secretary, The White House. (June, 2002). Fact Sheet: Africa Education Initiative. http://www.whitehouse.gov/news/releases/2002/06/20020620-18.html 2 Barro, Robert J. and Sala-i-Martin, Xavier. (1995). Economic Growth. McGraw-Hill, New York. pp. 424- 432. 3 II. Objective The goal of this paper is to survey the literature on education and its effects on economic growth. Over the last several decades, there have been a number of new developments and findings on this subject in both the micro and macro literature. Several recent models with policy implications are discussed. Where possible, we link the policy implications to growth-related issues faced by developing countries. Throughout this survey of the literature, we present mathematical concepts in a way that is accessible to less technical readers. III. Overview Economics offers a variety of theories and models relating education to economic growth. Education increases an individual’s earning potential, but also produces a “ripple effect” throughout the economy by way of a series of positive externalities. Katharina Michaelowa of the Hamburg Institute for International Economics diagrams the impact of education at both micro and macro levels as follows: 4 Source: Michaelowa, Katharina. (2000) “Returns to Education in Low Income Countries: Evidence for Africa.” http://www.hwwa.de/Projects/Res_Programmes/RP/Development_Processes/VfS_EL_2000_Rev2.pdf Direct and indirect effects of education are shown in the above diagram. Key assumptions underlying the diagram are: 1) education results in learning – it is not merely a “signal” of worker quality (see section V for more on signaling); 2) demand within the economy is sufficient to consume higher levels of output resulting from productivity gains; 3) monetary and fiscal policy are sufficiently responsive to meet the demands of a growing economy (to prevent deflation, the money supply grows at a rate equal to the growth rate of GDP). Direct effects of education such as increased individual wages follow from the assumption that education results in learning that increases a worker’s productivity. If workers are paid the value of their marginal product, it follows that better-educated workers should earn higher wages. Externalities and other indirect effects related to education, health, and population growth:  higher educ. attainment and achievement of children  better health and lower mortality of children  better individual health  lower number of births Lower population growth and better health of population (and labor force) Education Increased earnings (higher productivity) Increased earnin g s of nei g hbors Partici p ation in the labor force Hi g her g rowth Increased labor force micro macro Figure 1 5 In addition to the direct effects of education, a number of indirect effects have emerged in the literature. 3 Studies have found a “positive effect of [a] mother’s schooling on her children’s health in developing countries.” 4 Healthier children may be more productive than unhealthy children and the result may be higher performance in school. Similarly, better-educated parents tend to make more informed decisions with regard to family planning – the result being smaller family sizes. 5 Smaller family size enables more parental involvement in each child’s education (as parents’ time is scarce). Increased parental involvement in a child’s education may enable the child to perform better in school and encourage him or her to pursue additional years of education. An individual’s choice to pursue further education may improve the earnings of his or her neighbors. Michaelowa offers the example of an educated farmer who implements new agricultural techniques. Neighbors may observe the new methods used by the educated farmer and imitate them. Learning through observation is a mechanism by which such educational benefits may be spread within a community. 6 To quantify the private rate of return to education, we may regress individuals’ incomes on their level of education and other characteristics. 7 Linking a nation’s growth 3 For additional examples of externalities related to education beyond those mentioned here, we suggest: Heckman, James and Klenow, Peter. (1997) “Human Capital Policy.” http://www.klenow.com/HumanCapital.pdf 4 Michaelowa, Katharina. (2000) “Returns to Education in Low Income Countries, Evidence for Africa.” http://www.hwwa.de/Projects/Res_Programmes/RP/Development_Processes/VfS_EL_2000_Rev2.pdf Michaelowa references the following studies supporting positive correlations between parental education and children’s health: Glewwe (1999), Schultz (1993), Hobcraft (1993), and Thomas, Strauss and Henriques (1991). 5 Ibid. Michaelowa references the following studies with regard to the impact of education on family planning: Wolfe and Behrman (1984), Schultz (1989), and Behrman (1990). 6 Foster, Andrew. and Rosenzweig, Mark. (1995) “Learning by Doing and Learning from Others: Human Capital and Technical Change in Agriculture.” Journal of Political Economy, v.103, No. 6, pp. 1176-1209. 7 Here we refer to “education” as a quantifiable individual characteristic – methods used to quantify various aspects of education are discussed in section IV. 6 rate of GDP to its stock of human capital is more difficult. 8 Some empirical studies find human capital to be positively related to the growth rate of GDP; other studies find the linkage to be insignificant. 9 Some disagreement in the results of empirical studies arises from different measures of education and different definitions of human capital. Before reviewing the literature on education and economic growth, we discuss methods used to measure education. IV. The Measurement of Education An ideal measure of an individual’s education should capture several components, including the number of years spent in school, the quality of the schooling, the nature of the curriculum, and the student’s effort. Creating a measure that accurately quantifies these components is difficult. Of these components, an individual’s years of schooling is the only directly observable characteristic. We may indirectly measure aspects such as educational quality and individual ability and effort through standardized tests; however, there is disagreement regarding the reliability of such tests. 10 In microeconomic analysis that studies the variation in wages as a function of education, individuals’ years of schooling is frequently used as an independent variable. This method has advantages in that such data are readily available in developed countries, 8 “Human capital” has many interpretations and is discussed in greater detail in section IV. 9 Positive effects were found in the following studies: Mankiw, Romer, and Weil (1992), Levine and Renelt (1992), Barro (1991). Insignificant effects were found in the following studies: Pritchett (1997), Islam (1995), Caselli, Esquivel, and Lefort (1996). 10 The existence of an industry focused on standardized test preparation, racial disparities in test scores, and concerns over test-retest reliability have led to criticism of the use of standardized tests in recent years. For further information, see: Gordon, Edmund. (1995) “Toward an Equitable System of Educational Assessment.” Journal of Negro Education, Vol. 64, No. 3, pp. 360-372. 7 but it does not account for differences in the quality or type of education received. Alternatively, individuals may be classified by highest degree completed. This measure also has problems; for example, an individual nearly finished with college is counted as a high school graduate. In macroeconomic analysis, economists often include a variable for human capital. Because human capital encompasses a range of characteristics such as education, work experience, and health, it is extremely difficult to directly measure human capital. 11 Any measure of a country’s aggregate human capital must have the following characteristics: 1) it must be comparable across countries; 2) it must address the broad range of criteria that comprise human capital; 3) it must include elements of human capital for which data are available or estimable. An extensive literature discusses, proposes, and computes measures of human capital. 12 As the workforce’s education is a key component of an economy’s human capital, average years of education within the workforce may serve as a component of an estimate of an economy’s human capital. The use of averages, however, hides the distribution of educational attainment, which may affect an economy’s growth potential. An economy in which most individuals have a basic level of schooling may grow faster than one in which a minority of individuals have advanced educations while the remainder of the population has little to no education – as positive household-level externalities of education benefit a greater number of people in the former case. 11 Shupp, Frank. “Income distribution and endogenous growth: A review with an application to South Africa.” http://www.uct.ac.za/org/saner/doc_f/sanewp13.zip 12 For examples of various measures of human capital, see the following: Abowd, John, et al. (Aug. 2002) “The Measurement of Human Capital in the U.S. Economy.” Jeong, Byeongju. (Feb. 2001) “Measurement of Human Capital Input across Countries: A New Method and Results.” 8 In estimating an economy’s human capital, corrections for differences in educational quality again raise difficulties. Suggested quantitative measures of quality include “costs per student, library expenditures, number of earned doctorates among faculty and administrators … [and] student-faculty ratios.” 13 No consensus exists regarding the ideal combination of such measures in the formation of an index of educational quality. For example, a recent study found that per-pupil spending is a poor proxy for and index of school quality. 14 Alone, none of these measures provides much insight into the quality of education – a low student-faculty ratio, for instance, says nothing about faculty’s ability to teach. Techniques used to measure the education of individuals and the aggregate human capital of an economy are imperfect. Disagreement among researchers as to the “best” measure of various aspects of education and human capital makes it more difficult to compare the findings of empirical studies to determine the true impact of education on individuals’ incomes and economies’ growth rates. V. Microeconomic Theory Microeconomic analysis attempts to determine the effect of education on an individual’s wage. People invest in education up to the point where the marginal cost of additional education equals its marginal benefit. As an investment in human capital, a year of schooling produces a financial return by raising an individual’s income once he or 13 Conrad, Clifton and Pratt, Anne. (1985) “Designing for Quality.” Journal of Higher Education, Vol. 56, Issue 6. pp. 601-622. 14 Hanushek, Eric. (1996) “Measuring Investment in Education.” The Journal of Economic Perspectives, Vol. 10, Issue 4. pp. 9-30. 9 she enters the workforce. Following is a model that considers education to be an investment in human capital. The Mincerian Wage Equation: The Mincerian wage equation is a popular model for analyzing how an individual’s education and experience affect his or her wage. A basic assumption of the model is that all years of education generate an equal rate of return to the student – that is, kindergarten is just as important as a year of college. This assumption implies a linear relationship between the log of earnings and the number of years of education. 15 Second, we assume that the cost of an additional year of education equals the lost wages one might earn in that time. Finally, no accounting exists in this model for the quality of education received. Since this model views education as an investment in individual human capital, individuals choose how many years of schooling to pursue with the goal of maximizing the present value of lifetime earnings. Mathematically, agents choose s, (the number of years of education) to maximize: 16 Objective function: () () ∑∑ +== + + + = L s s r sM r PV 11 1 )( 1 τ τ τ τ τ γ (1) Subject to: Ms Msg s τ τ () () ( ) = − (2) The interest rate is denoted as r. The objective function represents the present value of lifetime income. The first term in the objective function captures the present value of an 15 Krueger, Alan and Lindahl, Mikael. (December 2001) “Education for Growth: Why and for Whom?” Journal of Economic Literature, Vol XXXIX pp. 1101-1136. 16 Wagstaff, Adam. (2001) “Deriving the Mincerian Earnings Function.” University of Sussex. http://www.sussex.ac.uk/economics/ma_micro/lec4.doc pp. 48-54. 10 individual’s income while he or she is a student. If we assume that students could only have earned income had they not been in school, γ becomes zero and this first term may be ignored. The second summation in the objective function represents the discounted value of lifetime earnings from the time the agent begins employment until the end of the planning horizon, denoted as L. Income in period τ is determined by M τ (s), a function of education, experience, and ability (see derivation in next section). An understanding of M τ (s) is crucial to understanding the Mincerian model. As s represents the agent’s years of schooling, M(s) must be increasing in s. The equation for M τ (s) contains a second term, g(τ - s), which captures the effect of experience, (τ – s), on a worker’s wage in period τ. The function g(.) is non-increasing in s, as less schooling leads to greater work experience in any given period τ. Mathematical Derivation: 17 Substituting the constraint for M τ (s) in the objective function, we have: () () () ()       + − ++ + + + + = −sLs r sLg r g r g r sM PV 1 )( 1 )2( 1 )1( 1 )( 2 (3) Rewriting (3) with summation notation results in the following: ∑ − = ++ = sL i is r ig r sM PV 1 )1( )( )1( )( (4) Defining a new function, G(.), we obtain equation (5): () ∑ − = + ≡− sL i i r ig rsLG 1 )1( )( , 17 We follow the derivation outlined in Wagstaff (see previous footnote) that offers an excellent, though more technical discussion of the Mincerian wage equation. [...]... extended the neoclassical model in ways that “emphasize government policies and institutions and the accumulation of human capital.”35 Much recent literature on growth seeks to answer the question of “why advanced economies … can continue to grow in the long run despite the workings of diminishing returns in the accumulation of physical and human capital.”36 Extensions of these models remain at the frontier... investment in education renders it of limited use in the policymaking arena Attempts have been made to generalize the Mincerian equation to estimate an economy’s geometric mean wage as a function of the labor force’s mean education. 33 As we turn to macroeconomic literature and its assessment of the relationship between education and economic growth, we shall examine the results of such “macro-Mincer”... diagram in figure 1 and the subsequent discussion of growth- related externalities of education 17 We shall consider in greater detail research into new growth theory, an outgrowth of the traditional neoclassical model The neoclassical growth model, developed in the mid-20th century, is a cornerstone of economic analysis; however it fails to distinguish between human and physical capital In the 1990s, researchers... Kingdom.” The American Economic Review, Vol 85, No 5 pp 1278-1286 13 their contemporaries, supports the notion that the true return to education may be twice that found through OLS estimation of the Mincerian wage equation.24 An ongoing examination of the rates of return to education throughout the world has been published throughout recent decades by George Psacharopoulos, applying the Mincerian model to the. .. models prior to current endogenous growth models that incorporate human capital VI Macroeconomic Theory Macroeconomic analysis of growth considers the rate of change of per capita GDP Using aggregate data to examine the relationship between education and growth in a macroeconomic framework, we can better grasp the effects of human capital externalities that affect growth. 34 These externalities are not evident... individuals make their choice of schooling based on the knowledge of the earnings function.22 Both cases are violations of the OLS assumption that the independent variable (years of schooling) is exogenously determined Researchers attempt to correct this problem through the use of instrumental variable techniques Harmon and Walker propose to “rely on exogenous changes in the educational distribution of individuals... solely with the aggregate well-being of its constituents; 4) the absence of a private market for education; 5) a population of like-minded individuals – students of equal education levels receive equal marginal benefit from increases to the present value of their lifetime incomes; 5) all externalities of education benefit individuals in the same way 32 Recall the higher rates of return to education for... frontier of current research into growth The Macro-Mincer Equation: The macroeconomic version of the Mincerian wage equation aggregates across individuals on an annual basis by using means of each variable Below is a simple example of such an equation:37 ln Yτ g = β 0τ + β 1τ Sτ + ε τ (12) Equation (12) expresses the log of the geometric mean wage ( Yτ g ) as a function of mean worker education ( Sτ... Krueger, Alan and Lindahl, Mikael (Dec 2001) Education for Growth: Why and for Whom?” Journal of Economic Literature, Vol XXXIX pp 1101-1136 38 The definition of mean worker education is subject to various interpretations as outlined in section IV 18 capita GDP growth As “most economies … subsidize human capital investments substantially,” the objective of Heckman and Klenow’s application of the macro-Mincer... in the absence 40 of subsidies To determine the size of a potential wedge between the social and private rates of return to education, Heckman and Klenow modify the Mincerian equation to allow for human capital externalities from education This modification is based on the idea that “controlling for own schooling, an individual worker may earn higher wages … the higher the level of schooling of other . The Impact of Education on Economic Growth Theory, Findings, and Policy Implications Brian G. Dahlin Duke University. offer predictions as to the implications of education policy changes on macroeconomic performance. Some empirical analyses of the growth rate of real per