An Alternative Approach

As alluded to earlier, it is important to further explore a number of potential adjustments to the typical earnings function approach of measuring returns to education. Firstly, if gross earnings are used in estimating Equations (2) or (3) for the private return to education, the interaction of increasing gross earnings and the tax/benefit system is ignored. In a progressive tax/benefit system, higher gross earnings will lead to more taxes and contributions and fewer benefits for an individual. Therefore, if we incorporate the tax/benefit system in measuring the marginal returns to education, rather than solely gross earnings, we may find that the redistributive nature of the tax/benefit system may create varying benefits to education to different individuals across the income distribution. From a fiscal viewpoint, this would suggest that as an individual’s income rises with education, government revenue should also see an increase, while its expenditure should fall. It also suggests that the net private benefit from education may not be as pronounced as when changes in gross earnings are solely taken as the measure of benefit.

The specification of the returns to education in both Equations (2) and (3) assumes that changes in earnings capture the full benefit of investing in education. This ignores the possible employment effect of education. Britton et al. (2015) and Oreopoulos and Petronijevic (2013) show, for Great Britain and the US respectively, that higher levels of education reduce the probability of being unemployed. Therefore, it can be implied that an individual that makes the transition from unemployment to employment due to extra education will see a high return to that education. Conversely, the return may be close to zero if an individual does not enter or leave the labour market post-education.

Integrating such factors in measuring the return to the individual may also help facilitate measurement of the fiscal returns. The possible interaction of education and tax/benefit liabilities implies that analysing the changes in taxes and benefits from a change in education relative to the public cost of this extra education can provide an estimate of the return the government receives from investing in education.

With respect to studies that have utilised the Mincerian approach, the role of the tax system has been incorporated in some studies by using net earnings in place of gross earnings in their estimations.2 For example, this has been undertaken in an Irish context by Denny and Harmon (2001) using data from 1987. They found that marginal returns to education were 2% lower for males and 3% lower for females using net rather than gross earnings as their dependent variable. However, this and other international estimates using net earnings ignore the role of labour force participation effects in measuring the net return to the individual from extra education. Furthermore, this framework does not facilitate the measurement of fiscal returns to education.

As mentioned in Sect. 9.1, a small number of studies have attempted to explicitly incorporate both a more detailed impact on overall gross income levels and the tax/benefit system into the measure of returns to education. In this chapter we follow the methodology outlined in Flannery and O’Donoghue (2016). Specifically, the net private return to third level education is:

Here, the numerator sums the net benefits to the individual from a change in education while the dominator reflects the costs to the individual from the same change. Specifically, YHE—YUppSec is the change in gross earnings in moving from upper secondary education to gaining a third level degree (or above). If we assume that gross wages increase as this change is made, this should be positive. However, this may be related to whether an individual is in work or not, which is accounted for with the probability term p_ew.

The term ssee is the employee rate of social insurance contributions while t is the income tax rate, all of which are conditional on gross earnings and the probability of being in work. bYHE represents the benefits received if the highest level of education attained is a third level degree or above, while bYUppSec signifies the benefits that one might receive with upper secondary education. These benefits (such as unemployment benefit) are generally dependent on gross earnings. Therefore, benefits with a higher level of education may be expected to be lower in a progressive tax/benefit system, and thus the term bYHE — bYUppSec is expected to lower the return to the individual.

On the cost side, Yn = Yj - Yc and is the net wage foregone during schooling (Yj is the foregone wage while in education and Y0 is the wage while a student) and p_es is the probability of being employed while in education. The term ssee is the employee social insurance contribution, t is the income tax rate, both of which will be dependent on Yn. bYn are the benefits foregone while in education and may include benefits such as unemployment assistance. Ep is the direct private costs involved in moving from one level of education to another. The net private return is therefore the value rprivate takes when the ratio of the marginal benefits and marginal costs is calculated.

In terms of the fiscal return to education, this is specified as:

Net benefits to the state are now the numerator of our equation while costs to the state constitute our denominator. In summary, Equation (5) illustrates that higher employment probabilities and higher earnings from a change in education levels may induce higher tax and social insurance revenues while lowering benefits. This may then represent a positive return to the state. There are some common terms across Equations (4) and (5) and their description remains the same. However, some of the terms change sign compared to Equation (4) to reflect the fiscal viewpoint. For instance, the term bYHE — bYUppSec is now subtracted within the numerator, as the expected drop in benefits received from increasing education will now create a positive fiscal return to the state. We also add the term sser to the numerator to capture employer social insurance contributions.

The cost element in the denominator of the fiscal return to education is similar to Equation (4). However, they are again adjusted to reflect the measurement of the return to the state rather than the individual. Higher levels of social insurance and income tax amounts foregone due to extra education now reduce the return, while the term Eg replaces the direct private cost of education and represents the public cost of varying education levels. The fiscal return is the value rfiscal when the ratio of the marginal benefits and marginal costs of education to the state are calculated.

 
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