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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.

Suggested Citation

  • Bas Jacobs & Sweder J. G. van Wijnbergen, 2007. "Capital-Market Failure, Adverse Selection, and Equity Financing of Higher Education," FinanzArchiv: Public Finance Analysis, Mohr Siebeck, Tübingen, vol. 63(1), pages 1-32, March.
  • Handle: RePEc:mhr:finarc:urn:sici:0015-2218(200703)63:1_1:cfasae_2.0.tx_2-9
    DOI: 10.1628/001522107X186683
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    Citations

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    Cited by:

    1. Azmat, Ghazala & Simion, Stefania, 2017. "Higher Education Funding Reforms: A Comprehensive Analysis of Educational and Labor Market Outcomes in England," IZA Discussion Papers 11083, Institute of Labor Economics (IZA).
    2. Dirk Schindler & Benjamin Weigert, 2008. "Educational and Wage Risk: Social Insurance vs. Quality of Education," CESifo Working Paper Series 2513, CESifo.
    3. Azmat Ghazala & Simion Ştefania, 2021. "Charging for Higher Education: Estimating the Impact on Inequality and Student Outcomes," The B.E. Journal of Economic Analysis & Policy, De Gruyter, vol. 21(1), pages 175-239, January.
    4. Ben Heijdra & Fabian Kindermann & Laurie Reijnders, 2017. "Life in shakles? The quantitative implications of reforming the educational financing system," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 25, pages 37-57, April.
    5. Bas Jacobs & Hongyan Yang, 2013. "Second-Best Income Taxation with Endogenous Human Capital and Borrowing Constraints," CESifo Working Paper Series 4155, CESifo.
    6. Dur, Robert & Glazer, Amihai, 2008. "Subsidizing Enjoyable Education," Labour Economics, Elsevier, vol. 15(5), pages 1023-1039, October.
    7. 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.
    8. Elena Del Rey & Bertrand Verheyden, 2008. "Loans, Insurance and Failures in the Credit Market for Students," Working Papers 359, Barcelona School of Economics.
    9. Ghazala Azmat & Ştefania Simion, 2021. "Charging for Higher Education: Estimating the Impact on Inequality and Student Outcomes," SciencePo Working papers Main hal-03873819, HAL.
    10. Joop Hartog & Luis Diaz-Serrano, 2015. "Why Do We Ignore the Risk in Schooling Decisions?," De Economist, Springer, vol. 163(2), pages 125-153, June.
    11. Elena Del Rey, 2011. "Deferring higher education fees without relying on contributions from non-students," Education Economics, Taylor & Francis Journals, vol. 20(5), pages 510-521, May.
    12. 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.
    13. Ghazala Azmat & Ştefania Simion, 2021. "Charging for Higher Education: Estimating the Impact on Inequality and Student Outcomes," Post-Print hal-03873819, HAL.
    14. Dirk Schindler & Benjamin Weigert, 2008. "Insuring Educational Risk: Opportunities versus Income," CESifo Working Paper Series 2348, CESifo.
    15. Ben J. Heijdra & Fabian Kindermann & Laurie S. M. Reijnders, 2014. "Life in Shackles? The Quantitative Implications of Reforming the Educational Loan System," CESifo Working Paper Series 5013, CESifo.
    16. Madonia, Greg & Smith, Austin C., 2019. "All-In or checked-out? Disincentives and selection in income share agreements," Journal of Economic Behavior & Organization, Elsevier, vol. 161(C), pages 52-67.

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    More about this item

    Keywords

    human capital; capital-market imperfections; credit rationing; financing risky investment; optimal education financing; graduate taxes; education subsidies;
    All these keywords.

    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; Loan Guarantees; Credits; Grants; Bailouts
    • I22 - Health, Education, and Welfare - - Education - - - Educational Finance; Financial Aid
    • 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

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