Higher education and the fall and rise of inequality

We investigate the effects of higher education on the evolution of income inequality. In so doing we propose a novel overlapping generations model with three social classes: the rich, the middle class, and the poor. We show that there is an initial phase in which no social class invests in higher education of their children such that income inequality is driven by wealth accumulation and bequests. Once a certain income threshold is surpassed, the rich start to invest in higher education of their children, which partially crowds out bequests and thereby reduces inheritance flows and income inequality in the short run. The better educated children of the rich, however, enjoy higher wage incomes later on in their lives such that income inequality starts to rise again, this time mainly driven by inequality in educational attainment. Over time, the middle class and potentially also the poor start to invest in higher education. As the economy proceeds toward a balanced growth path, educational differences between social groups and, thus, income inequality decline again. We argue that (1) the proposed mechanism provides a candidate explanation for the observed U-shaped evolution of income inequality and inheritance flows, as well as the differential investments in higher education by richer and poorer households, (2) the currently observed increase in income inequality is likely to level off in the future.