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Subsidies to Higher Education and Income-Tax Progression

PFM, Vol. 7 No. 4, (2007)

The impact of fiscal activity on human-capital formation has often been analyzed with regard to the expenditure side of the budget; i.e., the subsidization of (higher) education. However, recent contributions have increasingly focused on the effect of taxation on human-capital formation. Less attention has been given to the simultaneous effect of both subsidization and taxation. As subsidies to higher education may offset the distortionary effect of taxation, this paper aims to analyze the amount of subsidization that is necessary to counteract the discouraging effect of various kinds of income-tax progression on human-capital accumulation. An important policy advice derived from the analysis is that a country’s educational policies should be evaluated, not just by the levels of educational spending, but also by the level and structure of taxation.

The framework we use to illustrate our point is a two-period cohort model with heterogeneous agents, who endogenously decide on higher education with respect to taxation and subsidization. In this framework, we also demonstrate that subsidies may fail to offset existing tax distortions, limiting the optimistic view of some previous literature. In particular, we show that a second-best subsidy rate must be lower than unity. Otherwise an optimal subsidy rate leads to the problem of overeducation.

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