NN39, October 2007
Best Practice in Education and Training: Hype or Hope?
Rate Of Return To Education: Best Practice?
By Jandhyala B G Tilak, National University of Educational Planning & Administration, New Delhi
One of the most popular methods that has dominated the research in the area of Economics of Education for the last several decades has been the rate of return to education. Since the very formal heralding of Economics of Education in 1960 by Theodore Schultz (1961), researchers have estimated rates of return to education in many countries. That the method, a marginal improvement over the cost-benefit analysis, has been extensively used in most economic analyses of public investment projects, provides sufficient justification for its use in economic analysis of investment in education. Even in case of investment decision-making at the individual level, the cost-benefit framework has simple but strong relevance. In general, it has a powerful and strong logic, which appeals to all.The rate of return to education, to be more precise, the internal rate of return to education, is that rate of discount that equates the net present value of life-time earnings of the individual, taken as the benefits of education, to the net present value of costs of education. For investment in any project to be economically justified, the rate of return should be positive, and should be higher than the alternative rate of return. Among the several projects, investment in that project is preferred where the rate of return is higher, to the projects where it is lower. Alternatively rates of return to education are also estimated using Mincerian earnings function, originally proposed by Jacob Mincer (1972). But the full method of comparing costs and earnings has been more extensively used by researchers and it has also been controversial.
Among those who popularised this method, with a series of studies in various countries and a series of global updates (see, e.g., Psacharopoulos and Patrinos, 2004), George Psacharopoulos, formerly of the London School of Economics and then the World Bank, stands so tall that he was described by Mark Blaug (1987), another popularizer of Economics of Education, as Mr Rate of Return. Today estimates on rates of return are available on more than a hundred countries and Psacharopoulos himself estimated many of them.
As the estimated rates of return to education are found to be higher than, or at least comparable to, the rates of return to investment in other sectors of the economy, many welcomed the estimation of rates of return as providing a strong case for public investment in education. These estimates suggested that investment in education is justified not only for social and cultural reasons, but also strictly on the grounds of economic efficiency. It was hoped that this would compel the ministries of finance to treat education with due respect in the matters of allocation of resources, rather than providing resources as a charity and/or on a residual basis, i.e., allocating to education the resources that remained after allocating to all other sectors.
However, the method of rate of return has not been free from criticism. In the early 1960s itself (see, e.g., Merrett, 1966), the method was subject to severe criticism on the grounds that it assumes earnings of individuals as equivalent to their marginal productivity, or in other words, differences in productivity of people are reflected in their earnings? differentials. The method was also criticised in the earlier days for its inability to separate the influence of non-educational factors on earnings, for using simulated life time earnings profiles, etc. Theoretical improvements in the later years have answered some of this and other criticism. But the most important weakness of the method that still remains unanswered, relates to the inability of the method to account for non-economic benefits; it simply considers the earnings of the individuals ? pre-tax earnings as total social benefits, and post-tax earnings as private (or individual) benefits. The criticism becomes stronger and more valid in case of social rate of return, which is not a true social rate of return, as the social rate of return is also confined to considering earnings ? pre tax earnings of the individuals, and does not consider any non-economic benefits ? social, political, cultural, etc., which accrue to the society as a whole and which are generally referred to as ?externalities? in education. Though many economists of education do take note of the externalities, these externalities are rarely brought into the calculus of rate of return, simply because they are not measurable with any acceptable level of precision. As the externalities cannot be captured in the estimation, the efficiency of the principle of the rate of return is restricted in resource allocation. But instead of advocating it as a criterion to be supplemented by other considerations in investment decision-making, it has been mostly advocated as the sole criterion, which gave rise to several kinds of problems.
This criticism has assumed higher proportions in the 1980s, as the rates of return began to be advocated as a reliable sole criterion in public policy formulation on investment in education, and as the interpretation of the estimates of rates of return in the context of public policy led to somewhat dangerous implications. According to the estimated rates of return to education, primary education yields a higher rate of return than secondary education, which in turn yields a higher rate of return than higher education. Secondly, at every level of education, in general, private rates of return are higher than social rates of return. The policy implications of these estimates are clear: countries, particularly which are starved of public resources, should reallocate public resources in favour of primary education and withdraw from higher education; and since private rates of return are higher than social rates of return, individuals should be required pay high levels of fees and public subsidies could be drastically reduced. Though the later implication is valid for all levels of education, including primary education, the argument in the policy debates has been confined mainly to higher education and extended to some extent to secondary education. These policy implications turn out to be valid, if rate of return is considered as the sole criterion in investment decision making. But there is no justification for considering it as the one and the only criterion; it could have been supplemented by other considerations. As Psacharopoulos and others at the World Bank went on estimating rates of return to education in various countries and became strong advocates of their relevance and for rather exclusive reliance on them in policy formulation, and as the policy implications drawn within a narrow technical framework of economic efficiency were highlighted, policy makers and researchers from developing countries joined the critics and strong attacks are made on the very relevance of the method of rate of return to education. Rate of Return is viewed as a ploy and even as a capitalist conspiracy to see that developing countries do not develop strong higher education systems, would remain under-developed educationally as well as economically, and would forever remain dependent on the advanced countries. Some researchers (e.g., Bennell, 1996a,b, 1998) have also shown that the Bank and its researchers have distorted some of the research findings, or used small or inappropriate sample surveys, made simple averages, ignored more reliable database and research available, etc.
But given the overall influence of the World Bank on developing countries, many governments felt pressurised to change their policies of investment in education, particularly to give high priority to primary education at the cost of secondary and higher education. Perhaps very few governments did the same, out of any conviction on the relevance of the estimates of rates of return.
Thus the criticism of the rate of return method largely includes its incapability to consider the huge set of non-economic benefits, and even any economic benefits other than earnings, treatment of education essentially as an economic good, and the policy implications that follow, viz., reallocation of public resources in favour of primary education and away from higher education, and raising student fees and other user charges in secondary and higher education. The most important weakness of the method, viz., its inability to capture non-economic benefits of education led to the policy conclusions of the kind mentioned above. Because of the same reason, it is also felt difficult to explain why and how the social (or private) returns from higher education could be less than returns to primary education; or why do children go for higher education, when it is clear that the marginal private rates of return to higher education are less than those to secondary and primary education; or why rates of return to education are higher in developing countries than in advanced countries; and so on. The conflict between practicality versus rate of return is of late becoming increasingly clear. (see, e.g., http://econlog.econlib.org/archives/2007/03/education_pract.html)
Certainly the policy recommendation requiring an ill-treatment of secondary and higher education is widely seen rightly as the myopic vision of the economists of education for not being able to understand the inter-dependence of the various layers of education on one another in the education edifice on the one hand, and on the other their reluctance to note the importance of secondary and higher education in societal development, beyond the labour market, particularly in deepening democracy, building social harmony, nurturing the national and social values such as freedom, and in moulding a humane and civilised society.
The same problem of not being able to consider the non-economic benefits, also led many to argue that the whole underlying approach of the rate of return method is essentially anti-educational, as education which should not be considered as a normal economic good, is being considered as human capital and as any other economic good/service. The criticism assumes much more importance, as this contributed to viewing education as a commodity and the commoditisation of education has further helped in privatisation and vulgar forms of commercialisation of education in several developing countries, which further strengthen the forces that argue in favour of committing it to WTO and GATS for international trade. This, it is feared, would lead to the burial of the public good nature of education once for all. If so, should the blame go to the economists of education and to the rate of return method or to its zealous advocates and users who did not pay due attention to its limitations? After all, economics of education and the rate of return to education in particular have been useful in unraveling several phenomena in education. While the rate of return method is likely to stay, its value and relevance would certainly get enhanced considerably, if any attempt is made to capture the externalities and bring them into the rate of return calculations.
References
Bennell, Paul (1996a) Rates of Return to Education: Does the Conventional Pattern Prevail in Sub-Saharan Africa? World Development 24 (1): 183-99
Bennell, P. (1996b) Using and Abusing Rates of Return: A Critique of the World Bank?s 1995 Education Sector Review, International Journal of Educational Development 16 (3): 235-48.
Bennell, P. (1998) Rates of Return to Education in Asia: A Review of Evidence, Education Economics 6 (2): 107-20.
Blaug, M. (1987) Book Review of Economics of Education: Research and Studies, Journal of Human Resources 24 (2): 331-35.
Merrett, Stephen (1966) The Rate of Return to Education: A Critique,
Oxford Economic Papers, New Series, 18 (3) (November): 289-303.
Mincer, Jacob (1974) Education, Experience and Earnings. New York: National Bureau of Economic Research.
Psacharopoulos, G., and Harry A. Patrinos (2004) Human Capital and Rates of Return, in International Handbook of Economics of Education (eds.: Geriant Jones and Jill Jones), Cheltenham: Edward Elgar, pp. 1-57
Schultz, Theodore W. (1961) Investment in Human Capital, American Economic Review 51 (1) March: 1-17
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