The Causal Effect of Education on Aggregate Income

Empirical studies find that changes in schooling are not correlated with changes in per capita income. Similarly, the estimation in levels also produces minor coefficients for years of schooling. Low social returns and measurement error in educational variables have been invoked as possible explanations for such findings. This paper shows that collinearity between physical and human capital stocks seriously undermines the ability of educational indicators to display significance in panel data estimates. On top of that, failure to cope with endogeneity has produced biased estimates. As opposed to the earlier empirical literature, the social return on schooling is positive and significant, but no Lucas-type externalities are observed. Finally, the quality of education emerges as a significant determinant of heterogeneity in social returns across countries.