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Journal of Public Economics 71 (1999) 289309

Education, social security, and growth

Michael Kaganovich a , *, Itzhak Zilcha b

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

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
JEL classification: D90; D64; H55; I28






0047-2727 / 99 / $ see front matter 1999 Elsevier Science S.A. All rights reserved.
PII: S0047-2727( 98 )00073-5



M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309

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).

M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309


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
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),


M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309

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.

M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309


2. The benchmark model

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


where z, s, y $0 and z 1 s 1 y $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


where ai .0 for i51,2,3, c t y is the consumption when young, c t 0 the

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

M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309


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


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


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


s t ,e t

as well as condition (1) and e t $0.

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


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


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


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




Government taxes labor incomes to finance public expenditures related to

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


bt 5 (1 2 g )t w t ht


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
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, . . .


M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309

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



(iii) Market Clearing in the Capital Market:

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


(iv) For all t, x t and bt are determined by (10) and (11) for the given wage
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:
a1 c t0 5 ba2 c tyd s td 21 h t11


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


Using (1) we can rewrite condition (16) as:

a1 e t 5 sa3 c ty


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


a3 sA(1 2 t )wt ht
e t 5 ]]]]]]
a2d 1 (a1 1 a3 s )A


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

a2d 1 (a1 1 a3 s )A

h zt (w t h t )s 1 y

The equilibrium condition (13) implies

w t h t 5 (1 2 d )qt
Therefore, denoting


M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309


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


Now recalling that qt 11 5bs td h t12
11 we can apply condition (21) to obtain the
recursive relationship:

qt11 5 Mh(g )h tz (12d ) q td 1(s 1 y )( 12d )



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.,

a3 $ (yd )21 [(a1 1 a2 )t (1 2 d ) 1 a2 (st (1 2 d ) 2 yd )]

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

M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309


3. Stationary competitive equilibria

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


where, as previously, x t stands for the public investments (per-capita) in education

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


Thus we can write for all t50, 1, 2, . . . .

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


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


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


Finally, we denote by u the constant growth factor of the economy in stationary

state. This factor is different from 11r* since human capital is a factor of
production in this growing economy.


M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309

3.1. Stationary growth without education vouchers

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:

s* 5 ]] e*
a3 sA


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



c t 5 1 2 1 1 ]] e* (1 2 t )w*h t
a3 s A


Recall the relationship (17) and apply (26) to rewrite it as:

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


Combined with (28) and (29), this yields:

a3 sA
e* 5 ]]]]]]
a2d 1 (a1 1 a3 s )A
s* 5 ]]]]]]
a2d 1 (a1 1 a3 s )A


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


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


It now remains to substitute the expressions (31)(33) in the economys

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 )

M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309


3.2. Stationary growth with education vouchers

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


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


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
max(vt 1 e t )s x 12


s.t. (35)
If problem (37) has interior solution then:

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


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


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



M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309

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

12 s


Let x*, y * be the stationary fractions of governments educational outlays

devoted to public education and to vouchers, respectively. Then x*1 y *51 and
x t 5 x*tg w*h t


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


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


Substituting these expressions in (38) we obtain:

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


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


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 ]


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

u * 5 ]]]]]]]]]]]]]]]
a d3 21 Ad 21 [(a1 1 a3 )A 1 a2d ]


The formula (47) defines optimal fraction of an agents disposable income

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:

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


Let it be violated, so that agents optimal investment in private education is

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)

M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309

h t 11 5 v st x 12
5 s s (1 2 s )12 stg w*h t



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 ]


which leads to the expression:

a2d (1 2 t )(1 2 d )qt

s t 5 ]]]]]]
a1 A 1 a2d


By (13) the expression (50) can be rewritten as:

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


One can now substitute (52), (53) in qt 11 5bs td h t12
11 to find the stationary
growth factor u 5qt11 /qt which applies when e*50 is optimal, i.e., when
inequality (49) is violated:

ba d2d d (1 2 d )s s ( 12d ) (1 2 s )(12 s )( 12d ) (1 2 t )d (tg )12d

u 0 5 ]]]]]]]]]]]]]]]
Ad (a1 1 a2d /A)d


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

(1 2 t )a3 2 a1tg 2 a2dtg /A

x* 5 (1 2 s ) 1 1 ]]]]]]]]
tg (a1 1 a3 1 a2d /A)


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

t, g )
a3 $ ]]]]]]] a1 1 ] ; m(
1 2 t 2 s 1 st 2 stg



M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309

assuming that the denominator

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


Alternatively, if (12t )(12 s )2 stg #0, then x*,1 is always true.

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 *,

if a3 # m(
] t, g )
t, g )
if m(
3 # m(

if a3 $ m(t, g )

where u 0 , u *, u are given, respectively, by the expressions (54 ), (48 ), (34 ).

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

uy 5

u 0,
u *,

if a3 #
if a3 $

] t, g )
] 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:

d # 0.4; t # 0.4; s # 0.5


M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309


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:
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
(1 2 d )(1 2 t )(1 2 s )
G 5 ]]]]]]
t [d 1 s (1 2 d )]


Proposition 4.2. Let a3 $m(

] t, g ) and assume that the allocation parameter g # G.
t, g ), then uy 5u *,u.
Then uy #u. Moreover, if a3 ,m(

Proof. According to Lemma 3.1, uy 5u * when 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(
(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(


M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309

The number m 1 (t, g ) is increasing in g.

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.

5. Optimal government policy

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

M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309


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


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


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


u *
(ii) sign ]]

g 51

5 sign h(2 2 d )d (a1 1 a2 1 a3 ) 2 (1 2 d )a2 j,

u *

g 51

, 0,

if the following condition is satisfied:

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


(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 *.


M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309

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.
(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
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
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

M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309


g max 5 1 if a3 # m 0 (t, min(g *, g0 )),

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


M. Kaganovich, I. Zilcha / Journal of Public Economics 71 (1999) 289 309

situation where a fixed share of social security in public expenditures is

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
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.

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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