by Igal Hendal, Joel Shapiro, and Paul Willen
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.

Full text of Public Policy Discussion Paper 04-5