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Capital-Market Failure, Adverse Selection, and Equity Financing of Higher Education

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Author Info
Bas Jacobs
Sweder J. G. van Wijnbergen

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Abstract

We apply theories of capital-market failure to analyze optimal financing of risky higher education. In the market solution, students can only finance theireducation through debt. There is underinvestment in human capital because some students with socially profitable investments in human capital will not invest in education, due to adverse-selection problems in debt markets and because insurance markets for human-capital-related risk are absent. Legal limitations on the use of human capital in financial contracts cause this underinvestment; without them, private markets would optimally finance these risky investments through equity rather than debt and supply income insurance. The government, however, can circumvent this problem and implement equity and insurance contracts through the tax system by using a graduate tax. This paper shows that public equity financing of education coupled to provision of some income insurance is the optimal way to finance education when private markets fail due to adverse selection. We show that education subsidies to restore market inefficiencies are suboptimal.

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Publisher Info
Article provided by Mohr Siebeck, Tübingen in its journal FinanzArchiv.

Volume (Year): 63 (2007)
Issue (Month): 1 (March)
Pages: 1-32
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Handle: RePEc:mhr:finarc:urn:sici:0015-2218(200703)63:1_1:cfasae_2.0.tx_2-9

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Related research
Keywords: human capital; capital-market imperfections; credit rationing; financing risky investment; optimal education financing; graduate taxes; education subsidies;

Other versions of this item:

Find related papers by JEL classification:
H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
H24 - Public Economics - - Taxation, Subsidies, and Revenue - - - Personal Income and Other Nonbusiness Taxes and Subsidies
H52 - Public Economics - - National Government Expenditures and Related Policies - - - Government Expenditures and Education
H81 - Public Economics - - Miscellaneous Issues - - - Governmental Loans and Credits
I22 - Health, Education, and Welfare - - Education - - - Educational Finance
I28 - Health, Education, and Welfare - - Education - - - Government Policy
J24 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Human Capital; Skills; Occupational Choice; Labor Productivity

References listed on IDEAS
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Robert A. J. Dur & Amihai Glazer, 2005. "Subsidizing Enjoyable Education," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
    Other versions:
  2. Dirk Schindler & Benjamin Weigert, 2008. "Insuring Educational Risk: Opportunities versus Income," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
  3. Rita Asplund & Oussama Ben-Abdelkarim & Ali Skalli, 2007. "An Equity Perspective on Access to, Enrolment in and Finance of Tertiary Education," Discussion Papers 1098, The Research Institute of the Finnish Economy. [Downloadable!]
    Other versions:
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