Educational Opportunity and Income Inequality
by Igal Hendal, Joel Shapiro, and Paul Willen
Issue No. 2, September 2004 - December 2004
Motivation for the Research
Affordable higher education is, and has been, a key element
of social policy in the United States, with broad bipartisan
support. Governments at both the national and the state level
in the United States spend large sums of money to make education
affordable for the average American, and the public provision
of financial aid has substantially increased the number of
people who complete
university.
Facilitating broad access to higher education through public funding of financial aid to students is generally thought to be a good thing, but there has been less agreement on the justification for this. Many argue that education has positive social externalities, but others make the case that broader access to education promotes equality.
This paper questions the premise that broader access to education promotes equality.
Research Approach
The authors add credit constraints to Spence's (1973)
model of wage determination in which education does not enhance
productivity but serves only as a costly signal of ability.
Credit constraints enter the model because some workers-those
who do not receive bequests from their parents or whose bequests
do not cover the cost of education-must borrow at a high
interest rate to pay for their education.
The authors explore the implications of the model on labor markets analytically, giving particular attention to the impact on wage inequality of changing the cost of tuition and interest rates. They then extend the model to a multi-generation world and look at the dynamics of wealth distribution.
Finally, the authors examine the empirical evidence on financial aid and wage inequality and discuss the evidence in the context of the model.
Key Findings
- Making education more affordable can increase income inequality. When households face credit constraints, lack of education could mean one of two things: low ability; or high ability and low financial resources. Thus, the mix of less-educated workers includes some with high ability. As we relax credit constraints, high-ability workers leave the low-education pool, driving down the wage of less-educated workers.
- With credit constraints, a signaling role for education leads to an upward-sloping demand curve for unskilled labor. The authors assume that all workers of low ability forego higher education, implying that any increase in the quantity of less-educated workers reflects an increase in the proportion of high-ability workers in the less-educated pool, increasing the wage offered by firms to workers with low levels of education.
- Because of the upward-sloping demand curve, anything that reduces the supply of unskilled labor-like tuition assistance and low-interest education loans-and shifts the supply to the left, reduces the wage for unskilled labor and raises the skill premium.
- The dynamic model highlights the interaction between the skill premium and educational attainment over time. As more workers become educated, the wage of unskilled workers falls, making it increasingly difficult for uneducated households to accumulate the wealth required to finance an education.
Implications
The model reconciles the
postwar U.S. experience of increased availability of
higher education
with an increased skill premium. Specifically, government
programs in the United States led to a major expansion
of the skilled workforce in the postwar era. Between
1947 and 1999, the percentage of people 25 years
old and over who had completed four or more years of college
increased from 5.4 percent to 23.6 percent. According
to the standard labor demand/labor supply model with
a downward-sloping demand curve for unskilled labor,
this expansion of the skilled labor force and consequent
contraction of the unskilled labor force should have
led to a fall in the skill premium. By contrast,
the
model in Hendel et al. predicts an increasing wage
premium because of the upward-sloping demand curve. The
facts
support the upward-sloping curve: The college skill
6 research review premium in the United States rose in
the 1950s, flattened for the first half of the 1960s
before rising again in the second half of that decade,
fell in the 1970s, and began a very steep ascent
around 1979.
This paper suggests two natural directions for future research. First, one could explore how other factors that, in theory, might affect the relationship between wages and education interact with the mechanism described in the paper. Second, formal empirical tests could provide evidence on how changing financial opportunities have affected wage inequality.
