The profitability of investment in education : concepts and methods

/SZ93 Human Capital Development and Operations Policy HCO Working Papers The Profitability of Investment in Education: Concepts and Methods George Psacharopoulos November 1995 HCOWP 63  Papers in this series are not formal publications of the World Bank. They present preliminary and unpolished results of analysis that are circulated to encourage discussion and comment; citation and the use of such a paper should take account of its provisional character. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent.  The Profitability of Investment in Education: Concepts and Methods by George Psacharopoulos   Abstract This paper reviews the basic concept of the profitability of investment in education and enumerates the various techniques that have been used in the literature to estimate the rate of return to investment in education. The various estimating techniques are illustrated by using household srvey data from Venezuela and Guatemala. The paper also reviews the controversies that have appeared in the literature regarding the use of rates of return to investment in education for designing educational policy.   Contents Introduction ........................1 Basic Concepts .......................1 Private Rate of Return .......................2 Social Rate of Return ......................4 The Short-cut Method .......................5 The Reverse Cost-benefit Method ......................6 The Earnings Function Method ..7....................7 Refinements and Adjustments ........................ Country Examples ...................... 10 Controversies.............................................................................................................................13 References ............................................................................................................................... 16   Introduction The early 1960s witnessed what has been descnbed in the econonics literature as the "human investment revolution in economic thought" (Bowman 1966). Expenditures on education, whether by the state or households, have been treated as investment flows that build human capital (see Schultz 1961; Becker 1964). Once education is treated as an investment, the immediate natural question is: what is the profitability of this investment in order to compare it to alternatives? Such comparison can provide priorities for the allocation of public funds to different levels of education, or can explain individual behavior regarding the demand, or lack of demand, for particular levels or types of schooling. In the three decades that followed the human investment revolution in economic thought, hundreds of estimates have been made on the profitability of investment in education in all parts of the World and for all levels and types of schooling and training (for a review, see Psacharopoulos 1994). The purpose of this paper is to take stock of the conceptual and empirical issues surrounding the profitability of investments in education and provide a how-to compendium to assist in making firther estimations. The various techniques used are illustrated by actual country data drawn from household surveys. Basic Concepts The costs and benefits of education investments can be analyzed in the same way that these are calculated for other types of projects. In education, a series of expenditures occur during school construction and while students are in school, and benefits are expected to accrue over the life-cycle of the graduates. For establishing education investment priorities at the margin, the net present value or internal rate of return of the prospective operation can be computed. The discussion below focuses on the rate of return in order to ease comparisons with other projects. (Education projects do not typically yield more than one intemal rate of retur, hence the internal rate of return criterion gives the same answer as the net present value.)  2 The internal rate of return of an education project can be estimated from either the private or the social point of view. The private rate of return is used to explain the demand for education. It can also be used to assess the equity or poverty alleviation effects of public education expenditures, or the incidence of the benefits of such expenditure. The social rate of return summarizes the costs and benefits of the educational investment from the state's point of view, i.e., it includes the full resource cost of education, rather than only the portion that is paid by the recipient of education. Private Rate of Return The costs incurred by the individual are his/her foregone earnings while studying, plus any education fees or incidental expenses the individual incurs during schooling. Since education is mostly provided free by the state, in practice the only cost in a private rate of return calculation is the foregone earnings. The private benefits amount to what a more educated individual eams (after taxes), above a control group of individuals with less education. "More" and 'less" in this case usually refers to adjacent levels of education, e.g., university graduates versus secondary school graduates (see Figure 1). The private rate of return to an investment in a given level of education in such a case can be estimated by finding the rate of discount (r) that equalizes the stream of discounted benefits to the stream of costs at a given point in time. In the case of university education, for example, the formula is: 42 (W. - W.)t = + + (1) ~~~ (J+r/ +CutI r)  3 Figure 1: Stylized Age-earnings Profiles Ernf Unversiy graduates -wna wboad 0 Gg S~~~~~~~~~g ^~ ~2 65 AV 5 42 Dkuei Cost where (W.-W.) is the eamings differential between a university graduate (subscript u) and a secondary school graduate (subscript s, the control group). Cu represents the direct costs of university education (tuition and fees, books, etc.), and W. denotes the student's foregone eamings or indirect costs. A similar calculation can be made for the other levels of education. However, there is an important asymmetry between computing the returns to primary education and those to the other levels. Primary school children, mostly aged 6 to 12 years, do not forego earnings during the entire length of their studies. On the assumption that children aged 11 and 12 help in agricultural labor, two or three years of foregone eamings while in primary schooling have been used in the empirical literature. In addition, there may be no need to estimate a rate of return to justify investment in basic education - it is taken for granted that the literacy of the population is a goal that stands on its own merits for a variety of reasons other than economic considerations. However, as one climbs the educational ladder and schooling becomes more specialized, it is imperative to estimate the costs and  4 benefits of post-primary school investments, especially those in the vocational track of secondary education and higher education. Social Rate of Return The main computational difference between private and social rates of return is that, for a social rate of return calculation, the costs include the state's or society's at large spending on education. Hence, in the above example, C. would include the rental of buildings and professorial salaries. Gross earnings (i.e., before taxes and other deductions) should be used in a social rate of return calculation, and such earnings should also include income in kind where this information is available. A key assumption in a social rate of return calculation is that observed wages are a good proxy for the marginal product of labor, especially in a competitive economy using data from the private sector of the economy. Civil service pay scales are irrelevant for a social rate of return calculation, although they may be used in a private one. The "social" attribute of the estimated rate of return refers to the inclusion of the full resource cost of the investment (direct cost and foregone earnings). Ideally, the social benefits should include non-monetary or external effects of education (e.g., lower fertility or lives saved because of improved sanitation conditions followed by a more educated woman who never participates in the formal labor market). Given the scant empirical evidence on the external effects of education, social rate of return estimates are usually based on directly observable monetary costs and benefits of education (but see Summers 1992). Since the costs are higher in a social rate of return calculation relative to the one from the private point of view, social returns are typically lower than a private rate of return. The difference between the private and the social rate of return reflects the degree of public subsidization of education. The discounting of actual net age-earnings profiles is the most appropriate method of esfimating the returns to education because it takes into account the most important part of the early earning history of the individual. However, this method requires comprehensive data - one must have  5 a sufficient number of observations in a given age-educational level cell for constructing "well- behaved" age-eamnings profiles (i.e., not intersecting with each other). The Short-cut Method There is another method to arrive at approximate returns to education that is very easy to apply. Given the shape of the age-earnings profiles, one can approximate them as flat curves (see Figure 2). In such a case, the rate of return estimation is based on a simple formula: private r = - W@ (2) where W refers to the mean earnings of an individual with the subscripted educational level, and 5 is the length of the university cycle. The social rate of return in this case is simply given as: social r = W - W (3) S (W,+cg)' where C. is the annual direct cost of university education. Although the short-cut method is very easy to use, it is, by definition, inferior relative to any of the other methods described above. The weakness of the method lies in the abstraction that age- earnings profiles are concave, and that the discounting process Cn estimating the true rate of return) is very sensitive to the values of the early working ages entering the calculation.  6 Figure 2: Flat Profiles Untvmfty 6~~1 - (f Icmnduatum o 0 V 18 "23 6S Ap 5 42 *II (*m Dkind we The Reverse Cost-benefit Method This is based on the short-cut rate of return formula and amounts to asking the question: given the cost of the investment, what level of annual benefits would produce a given rate of return (10 percent, for instance) on the investment? AnnualBenefit = 0.10 (Education Cost), (4) or, in our case: (i -jW. ) = (0.10) [5 (