Optimal Educational Investment: Domestic Equity and International Competition

We construct a family of models to analyse the effect on optimal educational investment of (i) society's preferences for equity and (ii) competition between countries. The models provide insights about the impact of a variety of parameters on optimal policy. In particular, we identify a form of “overeducation” that is new to the literature and provide a counterexample to a common finding in the literature on fiscal federalism. 1. Introduction Economists’ interest in education often focuses upon the rate of return to schooling investments. Yet it is a characteristic of the education system in many countries that, for the most part, schooling is funded out of the public purse. While one might imagine that governments should seek to “equalise rates of return in all directions” [1], it is often the case that the authorities have broader objectives that inform their educational investments. For example, a government may have preferences about equity as well as efficiency. Or it may, for various reasons, be concerned to ensure that its own investment in its people’s skills does not fall behind investments made by other countries. We examine these issues by developing, in the next section, a series of models that can aid our understanding of how, under a variety of conditions, the optimal provision of publicly funded education is determined. 2. The Model In this section we present a family of related models of education and the tax system in order to provide insights into how governments can reach decisions about the optimal funding of education where (i) society has preferences about equity and (ii) decisions have impacts across countries. The basic structure of the model builds on the analysis of Johnes [2]. 2.1. Equity Suppose that the disposable income of individual is given by where is a basic income to be defined more precisely later, is a binary variable that indicates whether the th individual has undertaken schooling or not, is the proportional rate of income tax, and is the income premium associated with schooling. Both and are assumed exogenous. Tax revenues are used solely for the purpose of financing education which, we assume, takes place instantaneously. This distinguishes the model from a family of models typified by that of Bovenberg and Jacobs [3], where taxation also serves a redistributive purpose. In our model we keep the tax system simple in order to facilitate the extension to the international case in Section 2.2 below. In the present model, tax revenues fund education as a means of achieving the redistribution of income, but they could