Education Financing under Borrowing Constraints: Political Economy Implications for Intergenerational Fiscal Policy and Growth

This paper examines how borrowing constraints faced by young individuals shape the political allocation of public spending between pensions and education. We develop a threeperiod overlappinggenerations model with human capital formation in which individuals finance tertiary education privately through credit markets subject to borrowing limits. Fiscal policy—comprising pension benefits, non-tertiary education expenditures, public funding of tertiary education, and the labor income tax rate—is determined through probabilistic voting. Calibrating the model to Japan and the United States, we find that relaxing borrowing constraints lowers pension spending and the share of public funding for tertiary education while increasing tertiary education spending and economic growth; the response of nontertiary education spending is monotonic in Japan but hump-shaped in the United States. Based on projected declines in population growth, both countries are predicted to experience increases in pension spending and in the share of public funding for tertiary education, as well as decreases in spending on both non-tertiary and tertiary education and slower economic growth.