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Education, Social Security and Growth

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Michael Kaganovich a , *, Itzhak Zilcha b

b

a

Department of Economics, Indiana University, Bloomington, IN 47405, USA

The Eitan Berglas School of Economics, Tel-Aviv University, Ramat-Aviv, Tel-Aviv, 69978, Israel

Received 31 January 1997; received in revised form 30 September 1997; accepted 26 March 1998

Abstract

We study the role of governments allocation of tax revenues between two outlays: public

investment in education (a transfer to the young generation) and social security benefits to

the older generation. In an overlapping generations economy with pay-as-you-go social

security and altruistically motivated transfers from parents to children, we analyze how the

allocation of the tax revenues between the two outlays affects growth and welfare in

competitive equilibria: (a) we obtain comparative dynamics results for nonstationary

equilibria subject to a change in the allocation profile; (b) for stationary equilibria we show

that for a given allocation profile of the tax revenues, educational subsidies can either

increase the growth rate or decrease it depending on the parameters of the model

(preferences, production function and the tax rate); (c) if government seeks to allocate funds

in a way that maximizes the growth rate, we demonstrate that under some plausible

conditions it is not optimal to maintain pay-as-you-go social security; however, if parents

preferences combine strong concern for their retirement with significant degree of altruism

towards their children, then pay-as-you-go social security system does enhance growth and

welfare. 1999 Elsevier Science S.A. All rights reserved.

Keywords: Pay-as-you-go social security; Education vouchers; Altruism; Overlapping

generations

JEL classification: D90; D64; H55; I28

*Corresponding

author.

mkaganov@indiana.edu

Tel.:

11-812-8556967;

fax:

11-812-8553736;

0047-2727 / 99 / $ see front matter 1999 Elsevier Science S.A. All rights reserved.

PII: S0047-2727( 98 )00073-5

e-mail:

290

1. Introduction

The desirability of government intervention in the functioning of a competitive

economy arises in cases where the attained competitive equilibria are either

inefficient (due to externalities, for example) or fail to achieve certain important

social goals. In the twentieth century we witnessed worldwide phenomena of

intervention by governments in the provision of education and social security. In

most countries it is not only that a certain level of education is mandatory and is

provided by the government but also the higher education is heavily subsidized.

On the other hand, social security has been established in most developed

countries where it is financed by the pay-as-you-go system. It is commonly argued

that in both cases the competitive mechanism is unable to provide an efficient

equilibrium allocation (due to externalities or imperfect insurance markets) and a

desirable rate of growth.

Both social security and education can be viewed as a mechanism of intergenerational transfers. Although such transfers are altruistically motivated they have

significant effect on the growth process via their impact on the capital accumulation (see, for example, Feldstein, 1974; Kotlikoff and Summers, 1981; Modigliani,

1988; Bernheim, 1991) and the human capital accumulation (see, e.g., Lucas,

1988; Becker and Tomes, 1986; Gale and Scholz, 1994). However, it is known

that private altruistically driven decisions tend to yield inefficient competitive

equilibria. For example, this is the case when investments in childrens education

are determined, even partially, by altruistically-motivated parental decisions,

which ignore the positive impact that the human capital distribution has on the

aggregate production process (see, e.g., Eckstein and Zilcha, 1994). On the other

hand, social security may enhance welfare but may have an adverse effect on

output since it reduces savings (see, e.g., Feldstein, 1974; Laitner, 1988; Karni and

Zilcha, 1989).

We shall study the relationship between these two types of intergenerational

transfers in an overlapping generations model where the production factors are

physical capital and human capital. We consider individuals preferences with a

one-sided altruism of parents towards children. Namely, parents derive utility from

human capital of their children and hence invest during their productive period in

their childrens education. When parents retire, the labor income of their childrens

generation is taxed to finance their social security benefits. This link between the

human capital of children and the parents retirement benefits (in the form of

social security) is disregarded in each parental decision, but it is captured by the

governments social optimization. In the production of human capital we shall

treat the public investment and the private investment (made by the parents) as two

different inputs; thus the provision of education vouchers or subsidies, which has

been analyzed in recent years, becomes important from the efficiency point of

view (see for example, Glomm and Ravikumar, 1992, 1995; Fernandez and

Rogerson, 1993; Zhang, 1996).

291

We assume that government taxes labor income and allocates the revenues

between two outlays: public investment in educating the young generation (which

has consequences to the next periods aggregate output) and social security

benefits to the current retirees. This allocation rule of the tax revenues is taken to

be fixed over time once it is determined. Moreover, we shall distinguish a regime

where part of the governments education fund is allocated in the form of

education vouchers directly to the parents to be used in the education process of

their children and the other part is used by the government to cover public

education expenditures. In the alternative regime all the government education

fund is used directly in the education process. This paper demonstrates that there

are significant differences between these two (education-voucher and non-vouchers) regimes regarding the growth rate, and hence, the welfare implications.

We first study the nonstationary equilibria from a given initial capital stock and

show that, within a certain range, increasing the share assigned to education in the

allocation of government revenues results in higher economic growth in all

subsequent periods. Moreover, after some finite number of periods all generations

are better off in the new equilibrium.

We then proceed with the analysis of stationary equilibria where all the profiles

of resource allocation remain unchanged over time. For a given allocation rule of

the tax revenues between education and social security we compare the growth

rate in steady states with and without education vouchers. We find that, depending

on the parameters of the model, the growth rate in the steady state with educational

vouchers can be either smaller or larger than that in the steady state without

education subsidies. The magnitude of the altruism parameter (in the utility

function of the parents) plays an important role in such a comparison. (Abel and

Warshawsky, 1988 have estimated the altruism parameter for the joy of giving

bequest motive). We demonstrate that introducing education subsidies or vouchers

does not necessarily enhance economic growth (and consequently make consumers

better off). Finally, we consider the case where government can choose an optimal

allocation of funds between education and social security so as to maximize the

stationary growth rate of this economy. In this problem, government also has a

choice between the voucher and the non-voucher regimes. The main question here

is whether maintaining the social security program is compatible with the goal of

maximum growth rate. Under some conditions on the parameters of the model we

obtain that it is optimal to allocate funds for social security; however, under some

plausible conditions we also find that all tax revenues should be assigned to

education and hence the pay-as-you-go social security should not exist in the long

run.

The theoretical literature dealing with social security has concentrated on the

role played by these transfers in the aggregate saving of the economy (see, e.g.,

Feldstein, 1974; Hubbard and Judd, 1987), the financing system and the welfare

implications of social security (see, for example Samuelson, 1975; Diamond and

Mirrlees, 1978; Sheshinski and Weiss, 1981; Laitner, 1988; Sala-I-Martin, 1996),

292

its effect on income redistribution (see, e.g., Hu, 1978; Karni and Zilcha, 1989),

and its role in providing insurance due to imperfect insurance markets (see, Ulph

and Hemming, 1980; Eckstein et al., 1985). Most of the literature dealing with

public investment in education has analyzed its effects on growth, welfare and

income distribution. Levin (1997) studied the effectiveness of educational vouchers. Pecchenino and Pollard (1995) examined the effects of social security and

education on growth when education tax (imposed by federal government) is

determined through voting. They show that higher social security tax results in

lower capital accumulation and growth. In a model where government has no role

in education Zhang and Zhang (1996) relate social security to private investment

in education via its impact on fertility: under some conditions social security

lowers fertility and increases human capital investment and may enhance growth.

This possibility is consistent with our findings in Section 5 where we show that

maintaining social security results in higher growth when parents preferences

combine significant concern for their retirement income with strong degree of

altruism towards their children. Under such conditions, social security warrants the

parents future benefits resulting from the aggregate effect of human capital on

growth, and allows them to reallocate some of their income towards education of

their children, based on altruistic motives.

To the best of our knowledge, no paper in the literature considered the

relationship between these two public expenditures, education and social security,

which stems from the fact that both programs are financed by taxing labor

incomes. The allocation of tax revenues between these two important outlays,

which constitute different types of intergenerational transfers, needs to be

addressed and we consider our work as a first step. The main questions raised in

this paper are:

(a) Given some allocation of the tax revenues between these two provisions, is it

desirable to subsidize the private expenditures in education?

(b) If government wishes to maximize the stationary state growth rate and

chooses the optimal allocation of the tax revenues, is it desirable to use

education vouchers? Under what conditions the social security system should not

exist when such optimization criterion is used?

The paper is organized as follows. Section 2 describes the model and considers

nonstationary equilibria. Section 3 analyzes the stationary equilibria in this

framework with and without education vouchers. The comparison of the steady

state growth rates in the two regimes with and without education vouchers is

brought up in Section 4. In Section 5 it is assumed that government chooses the

allocation of tax funds optimally. Conditions under which it is optimal to

maintain the social security program in steady state are derived. Section 6 contains

a discussion of our results.

The proofs of some of the results have been omitted due to editorial

considerations. The appendix to the paper containing the proofs is included in the

mimeo version of this paper available upon request.

293

We consider an overlapping generations economy where an individual adults

life-span consists of two periods: Active adulthood and retirement. Members of

each generation are identical and supply inelastically one unit of labor during the

first period. Denote by h t the human capital of an individual in generation t,

denoted Gt , hence h t stands for her effective labor supply.

In this economy the government plays an important role in the provision of

education to the young and social security benefits to the old. Both activities are

financed by taxing the labor income at a (fixed) rate t. The evolution of human

capital process is as follows: The human capital of each individual in generation

t 1 1 is a function of the private investment in education (made by her parents) e t ,

the public investment in education (made by the government) x t , and the parents

human capital h t , namely:

h t 11 5 H(h t , e t , x t ) 5 h zt e st x ty

(1)

Thus the parents and the governments investments in education have a

different character as inputs in the human capital production process. However, the

two inputs are complements. For example, public and private investments in

education are complementary if parents invest time and money primarily in

preschool education (and perhaps college), while government has a major role in

financing elementary and secondary education. We assume that the parents

altruism towards their offspring is expressed via her / his human capital. Due to the

positive correlation between human capital level and earnings this implies

preference for higher lifetime income of their child. Each individual in Gt has the

following lifetime utility function:

Ut 5 (c ty )a 1 (c t0 )a 2 (h t11 )a 3

(2)

consumption in the retirement period and h t 11 the human capital of the offspring.

We take the economys aggregate production function F(Kt , Ht ) to be homogeneous of degree 1, where Kt and Ht are the aggregate physical capital and human

capital (which is identical to the effective labor). We assume no population

growth over time and that capital depreciates completely. The output, in per capita

terms, can be written as:

qt 5 bk td h t12d , where 0 , d , 1

where k t is the per-capita stock of physical capital in period t.

Let us consider now the optimization problem of an agent in generation t given

the tax rate t and the wage rate w t in period t, the rate of interest on saving r t 11

and the social security benefits in his retirement period bt11 . Note that when

294

agents are young they are in their first period of adulthood and hence invest e t in

educating their offspring. This agent chooses his saving s t , and thus his

consumption when old c t0 , his expenses on educating his child e t , (thus his

consumption when young c ty ), in a way that maximizes his lifetime utility

function, namely:

max(c yt )a 1 (c t0 )a 2 (h t 11 )a 3

(3)

s.t. c yt 5 (1 2 t )w t h t 2 s t 2 e t $ 0

(4)

c t0 5 (1 1 r t 11 )s t 1 bt 11 $ 0

(5)

s t ,e t

The unique solution of this problem satisfies the following necessary and

sufficient conditions:

a1 c t0 5 a2 (1 1 rt 11 )c yt , if st . 0

(6)

a1 c t0 $ a2 (1 1 rt 11 )c yt , if st 5 0

(7)

a1 h t11 5 a3 c yt H2 (ht , e t , x t ), if e t . 0

(8)

a1 h t11 $ a3 c yt H2 (ht , e t , x t ), if e t 5 0

(9)

or

or

education and social security. For simplicity we avoid taxing capital incomes

noting that in most countries such a tax does not exist. We denote by x t and bt the

public investment in education and social security payments at date t, respectively.

Denote by g, 0#g #1, the fraction of the government tax revenues allocated to

investments in education. In per-capita terms this means:

x t 5 gt w t h t

(10)

bt 5 (1 2 g )t w t ht

(11)

Given the initial capital stock k 0 , initial h 0 , and parameters t and g we say that

hc yt , c 0t , k t , s t , e t , h t ; w t , r t j `t 50 is a competitive equilibrium (CE) if:

(i) For each generation t given (w t , r t 11 , bt 11 ) and its human capital h t the

y

0

optimum for the problem (1), (3)(5) is (c t , c t , s t , e t ).

(ii) Competitive Factors Markets:

1 1 r t 11 5 F1 (k t11 , h t11 ) t 5 0, 1, . . .

(12)

w t 5 F2 (k t , h t ) t 5 0, 1, 2 . . .

295

(13)

k t 11 5 s t , t 5 0, 1, 2, . . .

(14)

(iv) For all t, x t and bt are determined by (10) and (11) for the given wage

process.

Thus, in equilibrium, interest factors are equal to the marginal product of

capital, under our assumption that capital depreciates completely, and wage rate is

equated to the effective labor marginal product at each date.

Since we assume nondecreasing returns in the production of human capital, then

in (1), (3)(5) corner solution e t 50 is excluded. Also s t 50 cannot hold in CE

since it implies that bt 11 50 and therefore c t0 50. Thus, due to (12)(14)

conditions (6)(9) can be replaced by the following two conditions:

12d

a1 c t0 5 ba2 c tyd s td 21 h t11

(15)

a1 h t11 5 sa3 c yt h tz e ts 21 x ty

(16)

a1 e t 5 sa3 c ty

(17)

By (4), (5), (10)(17) we derive the following expressions for the optimal

savings and the private investment in education in equilibrium:

a2d (1 2 t )wt ht

h t 11 5 ]]]]]]

a2d 1 (a1 1 a3 s )A

(18)

a3 sA(1 2 t )wt ht

e t 5 ]]]]]]

a2d 1 (a1 1 a3 s )A

(19)

where A5d 1(12d )(12g )t. Observe that the above values naturally depend only

on relative sizes of a1 , a2 , a3 . The expression (19) combined with (10) and

h t 11 5h zt e st x yt yield:

h t 11 5 [a3 s (1 2 t )] st yg y

A

]]]]]]

a2d 1 (a1 1 a3 s )A

h zt (w t h t )s 1 y

w t h t 5 (1 2 d )qt

Therefore, denoting

(20)

296

g y /s A

c (g ) 5 ]]]]]]

a2d 1 (a1 1 a3 s )A

we can rewrite the above expression as:

h t 11 5 [a3 s (1 2 t )] st y (1 2 d )s 1 y (c (g ))s h zt q st 1 y

(21)

d

Now recalling that qt 11 5bs td h t12

11 we can apply condition (21) to obtain the

recursive relationship:

(22)

where

g y (12d ) As (12d )

h(g ) 5 ]]]]]]]]

[a2d 1 (a1 1 a3 s )A] d 1 s (12d )

M 5 b[a2d (1 2 t )] d [a3 s (1 2 t )] s ( 12d ) (1 2 d )d 1(s 1 y )( 12d )t y ( 12d ) .

The following Proposition characterizes the changes in the competitive equilibrium path resulting from an increase of the share of public expenditure on

education out of the total budget as of period t50.

Proposition 2.1 (Comparative Dynamics Result). There is a constant g #1

determined by the parameters d, t, s, y such that the following statements are true:

Let the economy be initially in CE with parameter g , g and let the government

increase at t50 the share of public expenditure on education to some g [(g, g ),

then the CE corresponding to g satisfies:

(i) Output qt and human capital h t are strictly higher in all subsequent periods,

t51, 2, . . . .

(ii) Old-age consumption c 0t of all generations t$0 will increase.

(iii) For some finite K the young-age consumption c yt increases for all t$K and

hence the welfare Ut of all generations t$K is strictly higher.

Remarks. (a) If the maximand of the function c (g ) introduced above is less than

1, then this maximand defines the number g in the Proposition, otherwise g 51.

More details are provided in the appendix to this paper.

(b) It is possible to strengthen part (iii) of this theorem as follows: If the

altruism is significant, i.e.,

then Ut will be higher for all t$0; In other words the g 2CE allocation Pareto

dominates the g 2CE allocation.

297

We shall analyze in the sequel stationary growth equilibria in this economy

corresponding to different policies of the government with regard to its spending

on education. In particular, we shall study the role of the parameter g as well as of

education subsidies (vouchers).

A competitive equilibrium is stationary if:

(i) The proportions in the allocation of an agents (post-tax) income between

consumption, saving and investment in education remain unchanged over time.

(ii) Prices of factors (i.e., physical capital and human capital) remain unchanged

over time.

(iii) The economy grows at a constant rate.

The above conditions can be met only if the economys aggregate production

function exhibits constant returns-to-scale. The returns in the technology of goods

production have already been assumed constant. Henceforth, we shall also assume

constant returns in the production of human capital. Moreover, to simplify the

analysis in the sequel we disregard the effect of parents human capital on the

offsprings human capital level,

h t 11 5 e st x t12 s where 0 , s , 1

(23)

and e t is the private investment in education at date t. Later we shall consider

government subsidies to the private investments in education via vouchers.

In a stationary CE the wage rate (per unit human capital) w* and the interest

rate r* do not vary over time. An individuals allocation of income in stationary

state is determined by constants c*, s*, e* in [0, 1] representing respectively the

fraction of (after-tax) income allocated to consumption (in young-age), saving, and

private investment in offsprings education, hence:

c* 1 s* 1 e* 5 1

(24)

s t 5 s*(1 2 t )w*h t

(25)

e t 5 e*(1 2 t )w*h t

(26)

c yt 5 (1 2 s* 2 e*)(1 2 t )w*h t

(27)

state. This factor is different from 11r* since human capital is a factor of

production in this growing economy.

298

To derive the non-voucher stationary equilibrium let us apply expressions

(25)(27) together with w t 5w*, r t 5r* for all t in the equations attained in

Section 2 for nonstationary CE. In particular, using expressions (25) and (26)

combined with (18) and (19) we derive:

a2d

s* 5 ]] e*

a3 sA

(28)

where as previously, A5d 1(12d )(12g )t. Then expression (27) can be rewritten as:

F S

D G

a2d

y

c t 5 1 2 1 1 ]] e* (1 2 t )w*h t

a3 s A

(29)

a1

y

c t 5 ]] e*(1 2 t )w*h t

sa3

(30)

a3 sA

e* 5 ]]]]]]

a2d 1 (a1 1 a3 s )A

a2d

s* 5 ]]]]]]

a2d 1 (a1 1 a3 s )A

(31)

Due to our choice of production function we have w*h t 5(12d )qt , hence

according to (25),

s t 5 s*(1 2 t )(1 2 d )qt

(32)

Considering the expression (21) for the level of human capital h t 11 and

adjusting it to our assumptions in (23) we obtain:

h t 11 5 [a3 s (1 2 t )] st 12 s (1 2 d )(c (g ))s qt

(33)

production function to find the stationary growth factor u 5qt 11 /qt :

b(1 2 d )(a2d )d (a3 s )s (12d ) (1 2 t )12(12 s )( 12d ) (tg )( 12 s )( 12d ) As ( 12d )

u 5 ]]]]]]]]]]]]]]]]]]]

[a2d 1 (a1 1 a3 s )A] 12( 12 s )(12d )

(34)

299

So far we have assumed that the governments funds devoted to education are

entirely allocated to public education. Namely, the entire gt w t h t is invested in

education directly by the government in each period t. Since dollars spent by

parents on education of their offspring may be more effective than the same

amount spent by the government we shall consider now some transfers from these

public expenditures to private expenditures in the form of vouchers. As mentioned

previously, x t is the per-capita public investment in education, and let vt be the

size of education voucher given to parents in order to increase their private

expenditure on educating their child. Thus the allocation of the government funds

becomes:

x t 1 yt 5 gt w t h t , vt $ 0

(35)

bt 5 (1 2 g )t w t ht

Given the total government budget t w t h t , its portion devoted to education outlays

is determined by g. It is reasonable to assume that g is not subject to adjustment

on a current basis. Government, however, has much greater flexibility in the

allocation of the total education outlays gt w t h t between direct funding of public

education x t and subsidy to private expenditures related to education vt , so as to

maximize the effect on the production of human capital given by the expression

s

h t 11 5 (vt 1 e t )s x 12

t

(36)

In other words, taking g as fixed and the parents private investment in education

e t as given, government will determine x t and vt as the maximizers of

s

max(vt 1 e t )s x 12

t

(37)

s.t. (35)

If problem (37) has interior solution then:

s x t 5 (1 2 s )(vt 1 e t )

(38)

x t 1 vt 5 gt w t h t

Alternatively, in the case of a corner solution there will be no vouchers, i.e., vt 50.

Let us analyze the agents optimization problem (3)-(5) using the production

function of human capital (36). Initially assume interior solutions, then

a1 c t0 5 a2 (1 1 rt 11 )c yt

(39)

a1 (e t 1 yt ) 5 a3 s c yt

(40)

300

12s

h t 11 5 (yt 1 e t ) ]]

s

12 s

(41)

devoted to public education and to vouchers, respectively. Then x*1 y *51 and

x t 5 x*tg w*h t

(42)

vt 5 (1 2 x*)tg w*h t

(43)

e t 5 e*(1 2 t )w*h t

(44)

x* 5 (1 2 s )[1 1 e*(1 2 t ) /tg ]

(45)

We now use this expression together with (43), (44) in (41) and obtain:

h t 11 5 s s (1 2 s )12 s [tg 1 e*(1 2 t )]w*h t

(46)

Using the above relationships one can obtain the following expressions for

optimal stationary private investment in education and the stationary growth factor

of the voucher economy u *.

(1 2 t )a3 A 2 a1 Atg 2 a2dtg

e* 5 ]]]]]]]]

(1 2 t )[(a1 1 a3 )A 1 a2d ]

(47)

u * 5 ]]]]]]]]]]]]]]]

a d3 21 Ad 21 [(a1 1 a3 )A 1 a2d ]

(48)

devoted to education under two conditions:

(a) the expression (47) is positive,

(b) the interior solution (38) applies.

Condition (a) is equivalent to the inequality:

tg

a3 . ]] (a1 1 a2d /A) ;m(

] t, g )

12t

(49)

characterized by e*50. Observe that this cannot occur jointly with the no

vouchers corner solution since (41) would yield that h t 11 50. Thereby the

optimal solution of governments problem (37) is interior, hence it is determined

by condition (38) with e t 50, so that optimal stationary fractions of governments

educational outlays are: x*512 s, y *5 s. Therefore by (42), (43)

s

h t 11 5 v st x 12

5 s s (1 2 s )12 stg w*h t

t

301

(50)

Applying the first order optimality condition (39) for agents optimization

problem, which is not affected by the fact that e t 50, we get

a1 c 0t 5 a2 (1 1 r*)c yt

Recall the relationships of the model (4), (5), (10)(14) and use e t 50 to obtain,

since (11r*)s t 5d qt 11 , that:

a2d qt 11

a1 Aqt 11 5 ]]] [(1 2 t )(1 2 d )qt 2 s t ]

st

(51)

s t 5 ]]]]]]

a1 A 1 a2d

(52)

h t 11 5 s s (1 2 s )12 s (1 2 d )tg qt

(53)

d

One can now substitute (52), (53) in qt 11 5bs td h t12

11 to find the stationary

0

growth factor u 5qt11 /qt which applies when e*50 is optimal, i.e., when

inequality (49) is violated:

u 0 5 ]]]]]]]]]]]]]]]

Ad (a1 1 a2d /A)d

(54)

One can observe that the value of u equals to u * given by (48) when a3 5m(

] t,

g ).

It now remains to analyze the situation when the optimum in the governments

voucher provision problem (37) is in the corner x*51, i.e., no vouchers are

provided. This is only possible when optimal private investment in education e t is

positive, so that the expression (47) for e* applies. Substituting it in (45) one

obtains:

x* 5 (1 2 s ) 1 1 ]]]]]]]]

tg (a1 1 a3 1 a2d /A)

(55)

This corresponds to the interior unique solution of (37) when the above

expression is less than 1. Otherwise x*51 is optimal. Therefore, by (55) x*51

occurs iff

a2d

tg

t, g )

a3 $ ]]]]]]] a1 1 ] ; m(

1 2 t 2 s 1 st 2 stg

A

(56)

302

(1 2 t )(1 2 s ) 2 stg . 0

(57)

We can thus conclude that, if the inequality (56) holds, then no vouchers will be

issued so that the formula (34) for the stationary growth factor u in the economy

without vouchers will apply.

Remark. It is not hard to show that u *5u when (56 ) holds as equality.

Summarizing the above analysis we can state the following relationships for the

stationary growth factor uy for the economy with educational vouchers.

Lemma 3.1. Let condition (57 ) hold. Then the stationary growth factor uy for the

economy with educational vouchers satisfies the following relationships:

u 0,

uy 5 u *,

u,

if a3 # m(

] t, g )

t, g )

if m(

t

,

g

)

#

a

3 # m(

]

if a3 $ m(t, g )

Lemma 3.2. Assume that condition (57 ) does not hold. Then:

uy 5

u 0,

u *,

if a3 #

if a3 $

m(

] t, g )

m(

] t, g )

Thus the stationary growth rate with educational vouchers depends on the

degree of altruism represented by a3 in our model.

4. Steady state growth rates: the economy with and without vouchers

We shall now investigate the following important question: under what

conditions the provision of vouchers subsidizing private education may lead to

higher stationary growth rates or, alternatively, may reduce the growth rates. We

shall therefore compare the expression (34) for the stationary growth factor u in

the economy without vouchers, and the expressions given in Lemmas 3.1 and 3.2

for the stationary growth factor uy in the economy where educational vouchers are

being used by the government.

We shall impose the following restrictions on parameters of the model:

(58)

303

Remark. In our model 12d is the fraction of labor income in GNP. For the U.S.

economy, such fraction exceeds 0.7, so the condition d #0.4 appears reasonable,

as well as the restriction that tax rate t #0.4. Inequality s #0.5 means that

contribution of private education in overall production of human capital does not

exceed such contribution of public education.

Recall that in the economy with vouchers u * is the growth factor when e*.0,

while u 0 is the growth factor when e*50 is optimal. Note that inequalities (58)

guarantee condition (57), hence Lemma 3.1 applies under assumption (58).

The following propositions analyze the relationship between the growth rates in

stationary equilibria with and without vouchers. The degree of parents altruism a3

and the allocation parameter g play a major role. The next proposition provides a

characterization of the relationship between uy and u when a3 is extremely low.

Assume that (58) holds. There exists a positive number m 0 (t, g ),m(

] t, g ) such

that the growth factors satisfy:

0

Proposition 4.1. (i) uy 5u 0 ,u when m 0 (t, g ), a3 #m(

] t, g ); (ii) uy 5u .u when

0, a3 ,m 0 (t, g ). The number m 0 (t, g ) is strictly increasing in g.

We shall now extend the analysis to the case of higher parental altruism: a3 $m(

] t,

g ). We will need to consider the following value defined by parameters of the

model:

(1 2 d )(1 2 t )(1 2 s )

G 5 ]]]]]]

t [d 1 s (1 2 d )]

(59)

] t, g ) and assume that the allocation parameter g # G.

t, g ), then uy 5u *,u.

Then uy #u. Moreover, if a3 ,m(

] t, g )# a3 #m(t, g ), and uy 5u

t, g ). See the appendix for the proof that u *,u when a3 ,m(

t, g )

when a3 $m(

and g #minh1, G j. It remains to observe that G ,(12t )(12 s ) /st is always true.

t, g )

Hence the inequality stg ,(12t )(12 s ) is guaranteed when g # G so that m(

is well defined and Lemma 3.1 does indeed apply. j

In case G $1, Propositions 4.1 and 4.2 give a complete characterization of the

relationship between uy and u when g is anywhere in (0, 1]. If G ,1, then

Proposition 4.2 does not characterize the case of g [(G, 1].

Proposition 4.3. Assume that G ,g #1 and (58 ) holds. Then there is a number

t, g ) and the following relationships are

m 1 (t, g ) such that ]

m(t, g ),m 1 (t, g ),m(

true:

(i) uy 5u *,u when ]

m(t, g )# a3 ,m 1 (t, g )

t, g ).

(ii) uy 5u *.u when m 1 (t, g ), a3 ,m(

304

t, g ).

Remark. Recall that uy 5u when a3 $m(

Let us summarize these results along with Lemma 3.1 in order to obtain a

complete characterization of the relationship between stationary growth factors in

the economy with and without educational vouchers. Let the tax rate t and the

parameter g, the share of education outlay in the government revenues, be given.

Theorem 4.4. The relationship between u and uy is determined by the degree of

parental altruism a3 as follows. There exists a number m 0 (t, g ) such that:

(a) If 0,g #minh1, G j then, (i) uy .u if 0, a3 ,m 0 (t, g ), (ii) uy ,u if m 0 (t,

t, g ), (iii) uy 5u if a3 5m 0 (t, g ) or a3 $m(

t, g )

g ), a3 ,m(

(b) If G ,g #1 then there exists a number m 1 (t, g ) such that, (i) uy .u if

t, g ), (ii) uy ,u if m 0 (t, g ), a3 ,m 1 (t, g ),

0, a3 ,m 0 (t, g ) or m 1 (t, g ), a3 ,m(

t, g ) or a3 5m 0 (t, g ) or a3 5m 1 (t, g ).

(iii) uy 5u if a3 $m(

Discussion. The results of this section can be summarized in the following way.

The provision of vouchers will accelerate growth in two cases:

parental altruism is extremely low, so that parents do not invest enough in

private education.

parental altruism is very high and also the fraction g of educational expenditures in governments budget is very high.

Large g allows sufficient funds for both public education and the subsidy of

private education. A high degree of altruism ensures that the subsidy will not

significantly crowd out private investment. On the other hand, the provision of

vouchers will harm growth when a3 is not small while g is not too large (see

Theorem 4.4, parts (a)(ii) and (b)(ii)). The intuition behind this fact is that

vouchers will crowd out private investment in education by altruistic parents while

depleting the direct public spending on education.

We shall now consider the case where the allocation of tax revenues between

funding education and social security is no longer fixed, but can be chosen in an

optimal way. Namely, the value of parameter g in stationary equilibria is to be

chosen such that the steady-state rate of growth is maximized. As in Section 4, we

also assume that the government can choose between using and not using

305

educational vouchers, i.e., the choice of regime is also included in this optimization. The tax rate, however, is assumed fixed.

We shall be primarily interested in the questions if and under what conditions

the optimal value of g, g max , is equal to 1 (i.e., it is not optimal to maintain the

social security program); alternatively, when g max ,1, i.e., under what conditions

it is optimal to have it. In order to obtain conditions that are economically easy to

interpret we shall assume throughout this section that condition (58) holds; thus

the results of Section 4 are valid.

The following two conditions are crucial for the answers to the above questions.

(1 2 s )d $ s (1 2 d )t

(60)

(a1 1 a3 s )d (1 2 s ) $ a2 [st (1 2 d ) 2 (1 2 s )d ]

(61)

Condition (60) is met when the tax rate t is relatively low. If (60) is satisfied,

then (61) holds automatically. Alternatively, when (60) is violated, (61) imposes

an upper bound on the relative weight of the parameter a2 the extent to which

the agents are concerned about their retirement income relative to other priorities.

Consider the steady state growth rate u of the non-voucher regime, as defined in

(34). The following facts are proved in the appendix.

Lemma 5.1. (i) If either (60 ) or (61 ) is satisfied then u / g .0. (ii) If both (60 )

and (61 ) are violated, then there is g0 [(0, 1) such that

u

u

] . 0 for g [ [0, g0 ) and ] , 0 for g [ (g0 , 1]

g

g

Consider now the steady state growth rate u * corresponding to the interior

solution in the regime with vouchers, as defined in (48).

Lemma 5.2. (i) u * is a strictly concave function of the variable g ;

H U J

u *

(ii) sign ]]

g

g 51

thereby

u *

]]

g

g 51

, 0,

(2 2 d )d (a1 1 a2 1 a3 )

a2 . ]]]]]]]

12d

(62)

(iii) Subject to the condition (62 ), there is g *[(0, 1) such that u *(g ), as a

function of g, has unique maximum at g 5g *.

306

Denote by g max the optimal value of g as discussed above. Recall the definitions

of the values m(

] t, g ), m(t, g ), m 0 (t, g ), m 1 (t, g ) introduced in Section 3 and

Section 4. The above lemmas lead to the following results (see appendix for

detailed proofs).

Let G be the value defined in (59). Assume first that G $1, which is true if the

tax rate t is relatively low.

Proposition 5.3. Let G $1, then the following is true:

(i) If either condition (60 ) or (61 ) is satisfied, then g max 51.

(ii) Let a3 #m 0 (t, g0 ), where g0 is as defined in Lemma 5.1. If condition (61 ) is

violated, then g max 51.

max

(iii) Let a3 $m(

] t, 1). If condition (61 ) is violated then g ,1.

According to the above statement (iii), it is optimal to maintain social security

in this case. To interpret these circumstances, observe that the violation of (61)

means that a2 is relatively large, i.e., retirement income has high priority. In this

situation, the provision of social security allows parents to spend more of their

resources on childrens education. This argument is true only if the altruism

parameter a3 also is sufficiently high. Indeed, this can be seen from the conditions

in (ii) where social security does not exist. Observe that according to (i) and (ii)

low levels of altruism make social security nonoptimal regardless of other

conditions.

Assume now that G ,1. Then, according to Proposition 4.3, provision of

vouchers, combined with some private investment in education is an optimal

regime for values of a3 in some interval. Therefore, Lemma 5.2 is relevant for this

situation.

Lemma 5.4. Let G ,1, and let the condition (61 ) be violated. Then inequality

(62 ) is true.

Recall the parameters g0 and g * defined, respectively, in Lemma 5.1.and

Lemma 5.2. Now we state:

Proposition 5.5. Let G ,1, then the following is true.

(i) Assume that condition (61 ) is satisfied and that condition (62 ) holds. Then

t, 1);

g max 5 1 if either a3 # m 1 (t, g *) or a3 $ m(

t, 1).

g max , 1, if m 1 (t, 1) # a3 , m(

(ii) If either condition (60 ) or condition (61 ) is satisfied, but (62 ) is violated,

then g max 51 regardless of the value of a3 .

(iii) If condition (61 ) is violated, then

307

g max , 1 if a3 $ m 0 (t, 1)

Inequality (62) means that retirement income has high priority. Thus parts (i)

and (iii) of the proposition confirm the earlier conclusion: when high levels of

altruism are combined with significant concern for retirement income, then it is

optimal to provide social security. Its provision in such situations prevents

suboptimal crowding out of private investment in education by a competing

outlaysavings for retirement.

Similarly, we can summarize that provision of social security is not optimal in

our model if the agents concern for either retirement income or for childrens

education is low.

Remark. It should be emphasized here that our model disregards some important

roles played by the social security program: its insurance aspect under uncertain

lifetime and asymmetric information (see, for example, Eckstein et al., 1985), and

its role in income distribution (see, for example, Karni and Zilcha, 1989).

6. Discussion

This paper studies the effects that allocation of governments funds between

education and social security has on the economys growth rate and welfare in the

long run. These two government outlays are financed by taxes on wage incomes

and are widespread in todays developed economies. This issue has not been

addressed in the literature although there are many papers studying, separately, the

effects of human capital accumulation and social security on economic growth and

welfare. Clearly, the interrelation between these two major public expenditures

exists and hence the issue of optimal allocation of funds is an important one. In

our framework, higher investment in education results in later periods in higher

aggregate output in this economy and therefore in higher social security benefits

(given a fixed tax rate). Thus, if government can choose the allocation of its funds

that maximizes the long-run growth rate (and hence the long-run welfare level),

then, under some conditions we may find that there is no room for social security

program financed by pay-as-you-go system. On the other hand, we have shown

that for some parameter values in the model, the existence of such social security

program enhances the economic growth. We have studied these conditions in

stationary equilibria assuming that in addition to funding public education

government can choose to subsidize private education (via vouchers). In this

analysis we have ignored the political constraints on implementing government

policies.

The issue of desirability of education vouchers has also been studied here for a

308

maintained. The distinction and interrelation between the governments public and

parents private investments in education is in the essence of this analysis. As our

results show, an important parameter in our analysis is the intensity of altruism in

the preferences of the parents. Although such parameters are hard to estimate from

a given data on intergenerational transfers, it would be interesting to compare

different countries (or societies) from this point of view.

Given the growing difficulties that the Social Security Program is facing in

many countries, due to increasing life expectancy and the decline in population

growth, the research started here should be expanded. Our result that more

resources should be shifted to education needs to be examined in models with

heterogenous families and to consider fully-funded social security system as an

alternative.

In our economy each generation is homogenous, hence the issue of income

distribution is not reflected. Since education vouchers are financed by income tax,

its impact on income distribution is an important agenda for future research in

such a framework.

Acknowledgements

We are grateful to the anonymous referees for their stimulating comments and

suggestions which resulted in a significant improvement of the paper.

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