1. Chapter 11: Public Goods in Action – Education The single largest expenditure item for state and local governments is education, consuming about 30% of their budgets. The U.S. spends more per-pupil than nearly every country in the world, yet U.S. students perform only around the international average on reading, math and science ability. Figure 1 Figure 1 compares the U.S. to other nations in terms of money spent per pupil, and 8 th grade math scores.

2. Figure 1

3. Outline This lesson addresses numerous public finance issues in education policy: Why should the government be involved at all? How does public provision of education affect private education? How does school choice or vouchers affect efficiency? What is the return to education? What is the government’s role in higher education?

4. WHY SHOULD THE GOVERNMENT BE INVOLVED IN EDUCATION? The involvement of the government in elementary and secondary schooling is extensive: 90% of students in those grades are in public schools. Is there an economic rationale? Education is not a pure public good because it is: Rival: more children in a classroom lowers the quality of the experience. Excludable: private schools can decide which students to accept. What are the various rationales for government involvement in education?

5. Justification for Government Intervention #1: Productivity In general, the extra productivity from education is largely internalized. However, social benefits from higher productivity occur in two ways. The first is “spillovers” to other workers: a person’s productivity could raise the productivity of their coworkers, thus raising their wages and well being. The second is through taxes: if higher productivity is reflected in higher pay, then the government collects more tax revenues as a result.

6. Justification for Government Intervention #2: Citizenship Education may make people more responsible citizens, by participating to a greater extent in the democratic process and reducing the likelihood of criminal activity.

7. Justification for Government Intervention #3: Credit Market Failures Another justification may be credit market failures. In principle, a family could borrow against a child’s future earnings to finance the education, but unlike a home purchase, there is no collateral. The creditor cannot really observe if the child is a good risk to pay back the loan or not, and will generally offer too little credit in a situation like this. The solution to credit market failures would be to make loans available to finance education, but the government in the U.S. (and elsewhere) do not take on this role except in the financing of higher education. Rather, the government supplies a fixed level of publicly-funded education.

8. Justification for Government Intervention #4: Family Utility Even with well-functioning credit markets, there may still be failures to maximize family utility. Parents may not choose appropriate levels of education for their children; even with loans, private education would still involve some sacrifice on the part of parents, such as paying the cost of schooling not covered by the loans. Without public provision, some children would likely be penalized for having selfish parents.

9. Justification for Government Intervention #5: Redistribution In addition to motivations based on positive externalities, another key justification for public provision involves redistribution. Public education provides a level playing field that promotes opportunity.

10. HOW IS THE GOVERNMENT INVOLVED IN EDUCATION? Typically, to deal with positive externalities, the government uses either the price mechanism or quantity mechanism. In the context of education, the price mechanism would involve offering discounts off private educational costs. The quantity mechanism would be to mandate that individuals obtain a certain level of education. In practice, the government does neither. Instead, it provides a fixed level (12 years) of education at no cost. A problem with the system of public education provision is that it may crowd out private education provision.

11. Free Public Education and Crowding Out In fact, Peltzman (1973) argued that it is possible that providing public education could lower the educational attainment in society. In Peltzman’s model some parents choose lower- quality public schools over higher-quality private schools in order to take advantage of the free education entitlement. Figure 2 Figure 2 illustrates this.

12. Figure 2 Effects of free public education The slope of the budget constraint is determined by the relative prices of education and other goods. Education spending Other goods spending 0EFEF IC X IC Z IC Y Now suppose that the government provides free education that costs F. Initially, without free public education, parents choose between educational spending (educational quality) and other goods. Family X spends little on education for their children and send their kids to a low-quality school, and spends much more on other goods. Family Y spends more on education and sends their children to a medium-quality school. Finally, family Z spends even more on education and sends their children to a high-quality school. While the decision of family Z is unchanged. The children in family Y now consume lower quality education. The children in family X now consume higher quality education. A consumer must forgo the free education if they want a higher quality school.

13. Free Public Education and Crowding Out On net, public educational spending could crowd out private spending on education as individuals reduce their own spending in response to this free public option. Moreover, if enough families were like family Y in figure 2, then total educational quality could actually fall rather than rise.

14. Solving the Crowd-Out Problem: Vouchers Educational vouchers give parents a credit that can be used toward the cost of tuition at any school, public or private. Imagine a voucher of E F dollars that could be used for “free” public school, or for more expensive private schooling. Figure 3 Figure 3 illustrates this.

15. Figure 3 Effects of a voucher for $E F Education spending Other goods 0 EFEF IC X IC Z IC Y With a voucher, the budget constraint is different. You no longer have to forgo the public subsidy to get higher quality schools. The children in family X consume the same amount as before. The children in family Y now consume more education, not less. The children in family Z now consume more than before. C Y2Y2 Z2Z2

16. Solving the crowd-out problem: Vouchers The first argument in favor of vouchers is that they enhance consumer sovereignty, by allowing individuals to match their educational choices with their tastes. The second argument in favor of vouchers is that competitive pressures will allow the education market to work more efficiently. For example, real per-pupil spending has doubled since 1970, yet test scores have hardly changed. In addition, the number of administrative staff has grown by 50%, while the number of students has hardly changed.

17. Solving the Crowd-Out Problem: Vouchers In theory, vouchers put discipline on public schools by making private schools a more realistic option. Inefficient schools will be driven out of the education market, just as competition forces out inefficient firms. Of course, in principle there is already some degree of competitive pressure through the Tiebout mechanism.

18. Problems with Educational Vouchers: Specialization As schools try to specialize and attract customers, the benefits of a common program will be undercut. In principle, “football schools” or “art schools” could emerge to attract particular market segments. These schools could give less attention to what are viewed as the central elements of education. Accreditation and testing could ameliorate this problem.

19. Problems with Educational Vouchers: Segregation Vouchers have the potential to reintroduce segregation along many dimensions. This is more likely if children of disinterested or uninformed parents end up in low-quality public schools, while children of motivated parents end up in higher quality private schools. Alternatively, vouchers might allow motivated students to end the segregation imposed by neighborhood.

20. Problems with Educational Vouchers: Equity Figure 3 Another potential problem with vouchers is that some might consider them to be inequitable. In Figure 3, family Z used the voucher, yet education attainment rose only modestly. For families like family Z, who do not change their educational attainment by much, the voucher is basically the same as a cash transfer. To the extent that vouchers can be targeted to families such as Y, (rather than Z), then educational spending goes up by a larger amount. In practice, this is difficult to do.

21. Problems with Educational Vouchers: Economies of Scale and Costs Another problem is that the education market might be described as a natural monopoly. This is because there are fixed costs (such as the building) and economies of scale. In such a case, it is not efficient to have many small schools competing with each other. Finally, some students are more costly to educate. Special education students, for example, cost more than twice as much as the average student. Unless a voucher was commensurate with the cost of a student, schools have an incentive to cream-skim and avoid these costly students.

22. Experience with Public School Choice There have been some efforts to introduce greater competition in K-12 schools. Milwaukee has one of the most famous voucher programs. Instead of offering vouchers, some school districts have allowed students to choose freely across public schools. In other cases, magnet schools were set up to attract talented students. And in other instances districts allow charter schools that are not subject to the same regulations as traditional ones. There is some limited evidence of vouchers modestly improving educational outcomes. There is little evidence of beneficial effects from public school choice.

23. Experience with Public School Incentives While there is limited U.S. experience with vouchers and school choice, there is a much larger experience with school accountability. As of 2002, 25 states explicitly linked student promotion to performance on state or local assessment tests. 18 states rewarded teachers and administrators on the basis of successful student exam performance. 20 states penalized teachers and administrators for sub- par performance.

24. Experience with Public School Incentives This approach was codified into law with the No Child Left Behind Act of 2001. There is some evidence that strong measures of accountability had the intended effect of raising test scores. On the other hand, this sort of accountability had two unintended effects: Schools and teachers “teach to the test.” Schools may try to manipulate test scores by reclassifying low-skilled students as special-education, changing their cafeteria menus, and even cheating.

25. MEASURING THE RETURNS TO EDUCATION Government must undertake some sort of cost-benefit analysis when devoting resources to education. The costs are fairly straightforward, but the benefits are much trickier. The return to education is the benefit that accrues to society when individuals get more schooling, or when they get schooling from a higher quality environment. The literature shows that more education leads to higher wages, with a roughly 7% increase for each year of schooling. Intuition might suggest that education raises human capital, making a worker more productive and getting rewarded for that productivity in the market. On the other hand, in the screening model, education acts only as a mechanism of separating high and low ability individuals, but not actually improving skills.

26. Effects of Education on Productivity In practice, it is hard to separate the theories out, because true, underlying ability is unobserved. Researchers have used innovative techniques to control for the bias from underlying ability. The overall message of the literature is quite consistent: each year of education raises wages by 7 to 10%, after accounting for unobserved ability. This is strong evidence for the human capital model.

27. The Impact of School Quality A large literature has also examined the impact of higher quality schools on the returns to education. “Quality” is often defined as class size and spending per student. Experimental evidence from Tennessee suggests smaller class sizes lead to much higher test scores. Yet, a recent attempt to reduce class size in California did not have the expected positive effects, perhaps because other factors were changing too. For example, the rise in number of classrooms may have led the state to hire new, unqualified teachers.

28. THE ROLE OF THE GOVERNMENT IN HIGHER EDUCATION There is an enormous higher education sector in the U.S. Spending on higher education is about 40% of total educational spending. In contrast to other levels of education, higher education in the U.S. is viewed as an enormous success, with the best universities in the world and a vast inflow of foreign students. There are major differences in the degree of private provision and competition between higher education and primary/secondary education. In higher education, 23% of students attend private institutions, and individuals have free choice on which schools to apply to.

29. Figure 4

30. What Is the Market Failure? The returns to higher education are mostly private. Studies show there are some public returns to college education, they are not large relative to government expenditures. The major motivation for government involvement is failure of credit markets. Pell Grants and other financial aid can be rationalized by the concern that low income individuals will avoid loans because of short-sighted fears about loan repayments. For the state university, too many of you in-state students will leave Wisconsin after graduation! It is expensive to educate you, and for those moving out of state, the benefits of your work and the taxes you pay end up contributing to your new state of residence.