Higher Education Subsidies and Heterogeneity, A Dynamic Analysis

In this paper, we develop a simple dynamic general equilibrium framework that can be used to study issues in higher education policy. The model features heterogeneity in income of parents and academic ability of students. Liquidity constraints create persistence in educational attainment even when ability is independently distributed. A unique steady state with a positive fraction of college educated workers, or one with a development trap, or multiple steady states which feature both of these, can result in equilibrium. We add a government that is equipped with a simple tax scheme and calibrate the model to the US economy to get a benchmark for our policy analysis. The government can design a tax and subsidy scheme that guarantees equality of opportunity, but only at the expense of a decrease in the efficiency of utilization of education resources; the welfare gain is minimal. A policy that aims to maximize the fraction of college-educated labor, by sending as many children as possible to college, results in a big drop in the above-mentioned efficiency with little or no welfare gain. If the government has the political will to use any available signal on ability and provide merit-based aid, it can increase this efficiency with little decrease in welfare. Education subsidies may be a potent tool for countries that are caught in a development trap; a sufficient level of subsidy can cause the economy to emerge from the trap.