Evaluating an alternative to finance higher education: human capital contracts in Colombia.

AuthorLozano R., Felipe
PositionReport
Pages213(40)
  1. Introduction

    Governments in developing countries face a restricted budget to compensate for underinvestment in education. Great advances have been made in the coverage of basic education, but this is not necessarily the case in higher education. In Colombia and other developing countries, individuals with academic potential might not have the financial means to access the higher education system, and governments have limited resources to address this potential demand. The loss of opportunity for each individual regarding his full potential is accompanied by the loss to society in productivity and welfare that is derived from an individual's investment in education. The present article seeks to reinforce the use of an instrument called Human Capital Contracts (HCC), linking private investors to those individuals as a proposed solution to the above-mentioned situation.

    Recently, developments in the field of Finance have allowed the creation of different alternatives for long-term financing and investment, mainly through securitization and the deepening of world financial markets. These changes recall the idea of Friedman (1955) of investing in equity-like capital of individuals and their potential to generate income. Such investments take the form of Human Capital Contracts (HCCs), where individuals' future earnings are their collateral and source of resources to cover for an original investment.

    Palacios (2004) makes a clear case for the importance of education in development, and introduces the historical process that HCCs have gone through, presenting them as a partial solution to the problem of access to education. HCCs allow resources from private investors to be transferred to students without financial means in exchange for a percentage of their future income. Palacios (op. cit) uses the results from a study on education returns by Núñez and Sánchez (2000) (1) to valuate a hypothetical HCC drawn up for implementation in Colombia.

    This article drags heavily on Palacios (op. cit); however his analysis is taken one step further, focusing on the specific group of higher education graduates and their returns to education for HCC valuation. Previous studies in Colombia which focused on graduate students have tried to find determinants of graduate students' income (Forero and Ramirez 2008), but the aim of the article is to look exclusively at education returns for HCC valuation, and therefore to be the first study focusing on HCCs valuation in Colombia. Thereby, this article contributes to the literature of both Higher Education Financing and Economics of Education.

    Here a simple model of HCC is introduced, in order to evaluate the feasibility of HCCs in Colombia from the perspective of the economic incentives for investors and students. According to the results, returns to higher education in Colombia are high enough to provide an economic incentive for the implementation of HCCs to wholly finance public university programs, and partially finance private university programs, given the information available.

    This information is data from the Following Graduates Survey 2007 (FGS 2007) provided by the Labor Observatory of the Colombian Ministry of Education. A Modified Mincerian Approach and a Splines Model are used to estimate the returns to higher education, as they have been widely used in previous literature: Mincer (1974) for the US; Psacharoupoulos (1986) for a set of countries; Daniels and Rospabé (2005) for South Africa; Low et ál. (2004) for Singapore and finally for Colombia, Núñez and Sánchez (2000), Prada (2006) and García et Al. (2009).

    I have applied some modifications to the Classic Mincerian Model. Following García et ál. (2009), and for most of the functional form, Heckman, Lochner and Todd (2008) criticism' to the Mincerian equation is incorporated: Working hours, gender, and linear splines are included in order to account for non linearities between wage and education. Here, age, instead of the potential experience is used in order to avoid the correlation between education and experience which affects the meaning of the education coefficient (Heckman et al., 2008). Finally, we consider the life cycle earnings profile, built from the estimation, and compare the cash flow generated, to the direct costs of higher education in orther to valuate HCC.

    This paper neither addresses topics on the distributional characteristics of graduates' income and the risk it involves when investing in HCCs. This might overlook risk aversion issues. Other changes to the classic functional form, like cubic, or quartic forms on experience (Weldi, 2006), or correcting for bias selection (Heckman, 1979) are not included either, for the sake of simplicity or due to the lack of proper information. Specifically, the correction of selection bias involves the inclusion of variables that might explain the labor market participation decision. Those variables include household information like number of household members, number of kids under certain age in the houshold, information that infortunatelly was not available in the FGS 2007. Not testing for selection bias might lead to biased estimators. Other problems related with the FGS sampling are related to the potential bias towards a certain group of institutions, as 25 % of the observations come from 4 universities, institutions which are thereby overrepresented in the sample. These issues are mentioned and acknowledged but not solved in the present article.

    The article proceeds as follows: Section 2 presents a theoretical framework and reviews the most recent literature on education financing. Section 3 provides an overview of the Colombian higher education market. Section 4 presents the data from the FGS 2007. Section 5 presents the outcomes of the econometric exercises using OLS, Robust Standard Errors and Interval Regressions for the different model specifications. Section 6 presents Palacios (op. cit) example to valuate HCC, and the estimation using the outcome of Section 5. Section 7 concludes.

  2. Theorical Framework and Literature Review

    2.1. Economics of Education

    Education is viewed by some as an investment good (Mincer, 1958; Rebelo, 1991) in which individuals accumulate skills which are in turn matched by higher compensation in the labor market. That is the position of the Human Capital Theory (HCT). Education can also be seen as an investment that generates externalities, as it not only increases the productivity of the student but also the productivity of all factors (Lucas, 1988). Workers do not fully appropriate these because education has public good characteristics, according to the claim of the Endogenous Growth Theory (EGT). Lin (2007) analyzes the historical process of technological innovation that has evolved from exogenous shocks (that positively affected income) to endogenous ones produced by R&D made by people towards the technological frontier.

    Education can also be seen as a consumer's good (Schultz, 1961): individuals who demand it are striving for status or recognition. Finally, there is a screening hypothesis (Spence 1973), whereby education actually signals the existence of pre-education workers' abilities. Thus, education is not productivity enhancing for all factors but can be seen as an efficient device to screen individuals' abilities and thereby their productivities..

    Liquidity constraints affect the efficiency of market distribution of education. For the EGT and the HCT, solving the liquidity constraints on the students' side would help them to escape poverty traps as well as foster economic growth as a whole. Abiding by either, the screening or the education as consumption hypothesis, liquidity constraints would still act to prevent the attainment of optimal levels of education. In the case of Human Capital Contracts (HCCs), where private resources are transferred from savers to students, there is no debate regarding the positive effect on welfare enhancement that comes from their implementation. However, innovations of this nature might require some governmental support at the beginning, due to their risky nature. HCCs have the potential to correct these issues to a certain extent, so they are presented as a potential alternative to finance education.

    2.2. Financing Education

    Traditionally, societies have financed higher education with resources from the government-taxpayer and through direct financing of the individuals. By focusing on demand, government offers loans and subsidies to students or when focusing on supply issues, to Higher Education Institutions (HEIs). Direct financing can be made with savings and wages owned by individuals, their families and relatives; it also can be made through loans acquired in the private markets, which are often imperfect. Those resources are not enough to meet demand in developing countries.

    As mentioned previously, governments in developing countries face tight budget conditions. Measures that increase supply without increasing the public expenditure should be analyzed. There are two kinds of measures: those that increase efficiency of the resources already available, and those that increase the availability of resources. Competition mechanisms increase efficiency as universities are forced to compete for students, attracting them with improvements in their quality (i.e. vouchers). The availability of resources can be increased by graduate taxes and by involving the private sector in purchases of knowledge profitable in the market (research financing and student sponsoring).

    For students, ideal measures would recover costs without damaging the access. As low-income students do not have the resources, they have higher levels of risk aversion --the returns of education are more uncertain for them and the opportunity cost to attend lectures is higher-- and in most cases, they have no access to financial markets, which are actually imperfect for the case of education. If students...

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