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

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  • Bas Jacobs
  • Sweder J. G. van Wijnbergen

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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Bibliographic 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;

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References

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Citations

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Cited by:
  1. Robert Dur & Amihai Glazer, 2005. "Subsidizing Enjoyable Education," CESifo Working Paper Series 1560, CESifo Group Munich.
  2. Dirk Schindler & Benjamin Weigert, 2008. "Educational and Wage Risk: Social Insurance vs. Quality of Education," CESifo Working Paper Series 2513, CESifo Group Munich.
  3. Elena Del Rey & Bertrand Verheyden, 2008. "Loans, Insurance and Failures in the Credit Market for Students," Working Papers 359, Barcelona Graduate School of Economics.
  4. Rita Asplund & Oussama Ben Adbelkarim & Ali Skalli, 2008. "An equity perspective on access to, enrolment in and finance of tertiary education," Education Economics, Taylor & Francis Journals, vol. 16(3), pages 261-274.
  5. Dirk Schindler & Benjamin Weigert, 2008. "Insuring Educational Risk: Opportunities versus Income," CESifo Working Paper Series 2348, CESifo Group Munich.
  6. Lans Bovenberg, A. & Jacobs, Bas, 2005. "Redistribution and education subsidies are Siamese twins," Journal of Public Economics, Elsevier, vol. 89(11-12), pages 2005-2035, December.

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