It’s job market season, which is a great time of year for economists because we get to read lots of interesting papers. The one, by Dominik Sachs from Cologne and his coauthor Sebastian Findeisen, is particularly relevant given the recent Obama policy announcement about further subsidizing community college. The basic facts of marginal college students are fairly well-known: there is a pretty substantial wage bump for college grads (including ones who are not currently attending but who would attend if college was a little cheaper), many do not go to college even given this wage bump, there are probably externalities both in the economic and social realm from having a more education population though these are quite hard to measure, borrowing constraints bind for some potential college students but don’t appear to be that important, and it is very hard to design policies which benefit only marginal college candidates without also subsidizing those who would go whether or not the subsidy existed.
The naive thought might be “why should we subsidize college in the absence of borrowing constraints? By revealed preference, people choose not to go to college even given the wage bump, which likely implies that for many people studying and spending time going to class gives negative utility. Given the wage bump, these people are apparently willing to pay a lot of money to avoid spending time in college. The social externalities of college probably exist, but in general equilibrium more college-educated workers might drive down the return to college for people who are currently going. Therefore, we ought not distort the market.”
However, Sachs and Findeisen point out that there is also a fiscal externality: higher wages equals higher tax revenue in the future, and only the government cares about that revenue. Even more, the government is risk-neutral, or at least less risk-averse than individuals, about that revenue; people might avoid going to college if, along with bumping up their expected future wages, college also introduces uncertainty into their future wage path. If a subsidy could be targeted largely to students on the margin rather than those currently attending college, and if those marginal students see a big wage bump, and if government revenue less transfers back to the taxpayer is high, then it may be worth it for the government to subsidize college even if there are no other social benefits!
The authors write a nice little structural model. People choose to go to college or not depending on their innate ability, their parent’s wealth, the cost of college, the wage bump they expect (and the variance thereof), and their personal taste or distaste for studying as opposed to working (“psychic costs”). All of those variables aside from personal taste and innate ability can be pulled out of U.S. longitudinal data, performance on the army qualifying test can proxy for innate ability, and given distributional assumptions, we can identify the last free parameter, personal taste, by assuming that people go to college only if their lifetime discounted utility from attendance, less psychic costs, exceeds the lifetime utility from working instead. A choice model of this type seems to match data from previous studies with quasirandom variation concerning the returns to college education.
The direct benefit to the government from higher tax revenue from a subsidy policy, then, is the cost of the subsidy times the number subsidized, minus the proportion of subsidized students who would not have gone to college but for the subsidy times the discounted lifetime wage bump for those students times government tax revenue as a percent of that wage bump. The authors find that a general college subsidy program nearly pays for itself: if you subsidize everyone there aren’t many marginal students, but even for those students the wage bump is substantial. Targeting low income students is even better. Though the low income students affected on the margin tend to be less academically gifted, and hence to earn a lower (absolute) increase in wages from going to college, subsidies targeted at low income students do not waste as much money subsidizing students who would go to college anyway (i.e., a large percentage of high income kids). Note that the subsidies are small enough in absolute terms that the distortion on parental labor supply, from working less in order to qualify for subsidies, is of no quantitative importance, a fact the authors show rigorously. Merit-based subsidies will attract better students who have more to gain from going to college, but they also largely affect people who would go to college anyway, hence offer less bang for the buck to government compared to need-based grants.
The authors have a nice calibrated model in hand, so there are many more questions they ask beyond the direct partial equilibrium benefits of college attendance. For example, in general equilibrium, if we induce people to go to college, the college wage premium will fall. But note that wages for non-college-grads will rise in relative terms, so the net effect of the grants discussed in the previous paragraph on government revenue is essentially unchanged. Further, as Nate Hilger found using quasirandom variation in income due to layoffs, liquidity constraints do not appear to be terribly important for the college making decision: it is increasing grants, not changing loan eligibility, that will do anything of any importance to college attendance.
November 2014 working paper (No IDEAS version). The authors have a handful of other very interesting papers in the New Dynamic Public Finance framework, which is blazing hot right now. As far as I understand the project of NDPF, essentially we can simplify the (technically all-but-impossible-to-solve) dynamic mechanism problem of designing optimal taxes and subsidies under risk aversion and savings behavior to an equivalent reduced form that essentially only depends on simple first order conditions and a handful of elasticities. Famously, it is not obvious that capital taxation should be zero.