Optimizing Public Investment : Choosing between Physical and Human Capital when the Rate of Return to Physical Capital Exceeds that of Human Capital

How should the government redistribute current income in an economic environment where more education by private agents crowds out physical capital, causes an excessive increase in the rate of return to physical capital relative to human capital, and lowers economic growth? Should the government redistribute current income by subsidizing human capital or physical capital accumulation? We compare these two policy options in a heterogeneous two-sector OLG model with model features tailored to that of least developed countries (LDCs). Both policies are growth-improving, but only the subsidization of human capital accumulation is welfare-improving. Moreover, subsidizing human capital accumulation also causes more economic growth than subsidizing physical capital accumulation. In accounting for growth, we find that the general equilibrium effect greatly dominates that of physical capital in our educational subsidies model. In contrast, the physical capital effect dominates the general equilibrium effect in our physical capital subsidies model. Overall, our results support direct government policies that subsidize human and physical capital accumulation in LDCs, but not government action that indirectly relaxes borrowing constraints, such as deregulating the private student credit market