An Economic Rationale for Investing in Human Capital

There are compelling economic arguments for governments to invest in the human capital of their people—limited access to credit narrows household choices, information failures distort investments, and spillover effects lead to suboptimal family investments. Lack of access to capital is one reason for governments to invest little in human capital—a problem that natural resource revenues can help to overcome. Investing in human capital should be an important part of the portfolio of investments using resource revenues—along with investing in infrastructure and saving through mechanisms, such as sovereign wealth funds, that allow countries to earn international rates of return on investments. A balanced portfolio is desirable, and investing in human capital has a special role to play in resource-rich settings— especially in poor countries—where the need for human capital and infrastructure investments is large. The indirect effects of enhancing human capital on reducing the incidence and cost of conflict are also a large part of the story. Why Governments Should Invest in Human Capital “Perfect Markets” as a Reference Point When markets are functioning perfectly, households have a full range of choices about how to invest their disposable income. They can use their cash for consumption, savings, investing in education and training, and various other types of spending or investing. Since each type of spending has diminishing benefits, at least eventually, people would adjust their spending so that, as economists put it, the marginal returns are equalized across different types of spending. If markets were “perfect,” an additional dollar spent on building human capital would yield the same return as the interest rate obtained through savings. If it were higher, households would increase their spending on skills acquisition (perhaps financed 60 An Economic Rationale for Investing in Human Capital From Mines and Wells to Well-Built Minds • http://dx.doi.org/10.1596/978-1-4648-1005-3 by borrowing) until the marginal return were equalized—and the ultimate household level of investment in human capital would be optimal. In such perfect and complete markets, there would typically be no scope for the government to invest in building human capital, since households would behave optimally. However, markets are rarely perfect or complete. Indeed, the economic literature has identified several market “failures” that motivate public investments in human capital. This chapter reviews capital market failures, incomplete information, behavioral biases, and externalities. Credit Constraints Since private returns to human capital are high (box 2.1), it would seem inconceivable that households might choose not to send children to school. Even for very poor households, borrowing to invest in at least some years of education would be optimal. But financial markets are obviously not perfect, and studies Box 2.1 Private Returns to Human Capital While human capital is a broad concept that encompasses not only formal education but also skills, capabilities, and even health, estimating the effects of formal schooling has received the lion’s share of scholarly attention. The literature on returns to education gives solid support to the notion that private returns are meaningful. A long economic tradition estimates private returns to education following a human capital approach and estimating so-called “Mincer regressions” that relate earnings to schooling and experience while controlling for a battery of factors (Becker 1975; Mincer 1958, 1974; Schultz 1960, 1961). Mincer regressions typically show large returns from education. For example, Psacharopoulos and Patrinos (2004) found that the average rate of return on an additional year of schooling is 10 percent and that the returns are especially high for primary education in lowand middle-income countries. Schultz (2004) and Filmer and Fox (2014), focusing specifically on Africa, found that returns increase at higher levels of education. It is difficult to separate the effects of schooling on productivity from its signaling value. It could be that graduates of higher education do not earn more because of the productivityenhancing skills they have learned but because their admission to prestigious schools acts as a signaling device for classifying whether individuals have high or low innate ability (Brown and Sessions 2004; Spence 1973). The use of “natural experiments” allows analysts to distinguish the two effects. Card (2001) surveyed the growing literature that draws on natural experiments for estimating the return to schooling and found that, in many cases, the returns are similar to those of traditional Mincer regressions. For example, the estimate of Leigh and Ryan (2008) for Australia is about 10 percent, in line with Mincer regression estimates for comparable countries. Ozier (2015) found that attaining secondary school in Kenya causally leads to a decrease in the probability of low-skill (and low-earning) self-employment and an increase in the probability of (higher-earning) formal employment. Formal schooling is, of course, not the only way to raise human capital and earnings. A substantial literature shows that better nutrition for pregnant women and infants raises schooling box continues next page An Economic Rationale for Investing in Human Capital 61 From Mines and Wells to Well-Built Minds • http://dx.doi. org/10.1596/978-1-4648-1005-3 show that households underinvest in education when capital markets are imperfect (Becker 1967; Cordoba and Ripoll 2013; Fiszbein and others 2009; Lochner and Monge-Naranjo 2012). Because poverty and inequality today can breed poverty and inequality tomorrow, state intervention may be desirable (Banerjee and Newman 1993; Galor and Zeira 1993). The evidence is not only theoretical. Empirically, capital market frictions have been found to drive underinvestment in education (Lochner and Monge-Naranjo 2011). This has been shown for the United States (Carneiro and Heckman 2002) and for Mexico (Attanasio and Kaufmann 2009; Kaufmann 2014), as well as in an analysis of cross-country data (Flug, Spilimbergo, and Wachtenheim 1998). Borrowing constraints are a significant factor contributing to the large schoolingwealth gap in developing countries, with children from rich families much more likely to be enrolled at all levels of education (Filmer and Prichett 1999). Incomplete Information Though important, capital constraints are not likely to be the whole story. Even when returns on human capital are high, people may be reluctant to invest in it levels and economic productivity (Victora and others 2008). Strauss (1986), for example, found a very substantial positive impact of caloric intake on labor productivity in Sierra Leone. Further, comparing twins, Behrman and Rosenzweig (2004) and Black, Devereux, and Salvanes (2007) found that lower birthweight has a serious impact on future educational attainment and earnings. These findings suggest that government programs to promote sufficient and balanced nutrition during pregnancy can help to boost human capital and economic output. Weil (2007) used such microeconomic estimates from various sources to estimate aggregate returns to health. He found that eliminating health differences between countries would reduce the variance of gross domestic product (GDP) per worker by nearly a tenth. Substantial scholarly attention has also been devoted to early childhood development. It has been found that both cognitive and noncognitive skills acquired in preschool significantly shape later education and labor market outcomes (Almond and Currie 2011). Several preschool intervention programs have had very high returns (Heckman 2006). For example, the Perry Preschool Program in the United States, which enrolled disadvantaged children starting at ages 3–4 and included both school programs and home visits, resulted in laterlife higher scores on achievement tests, high school graduation, and homeownership and lower rates of receipt of welfare assistance, out-of-wedlock births, and arrests for crime. The economic return rates for the program were 15–17 percent. The Abecedarian Program, also in the United States, enrolled participants at only 4 months of age and provided intensive day-long child care. It was found to permanently raise intelligence quotient (IQ) scores and noncognitive skills. A long-run study in Jamaica showed that cognitive stimulation in early childhood resulted in substantial increases in earnings in adulthood (Gertler and others 2014), as did a nutritional intervention among severely stunted children in Guatemala (Hoddinott and others 2008). Box 2.1 Private Returns to Human Capital (continued) 62 An Economic Rationale for Investing in Human Capital From Mines and Wells to Well-Built Minds • http://dx.doi. org/10.1596/978-1-4648-1005-3 if they are poorly informed about its benefits. Indeed, inaccurate beliefs about the average returns to education seem to play a major role. For example, studies in Madagascar (Nguyen 2008) and the Dominican Republic (Jensen 2010) found that many young people drastically underestimate the returns to schooling, and this reduces school attendance. Disseminating information to correct this underestimate was effective at boosting enrollment rates in both countries. Behavioral Biases Even with appropriate information, people have behavioral biases that help account for underinvestment in human capital (see Fiszbein and others 2009 for a comprehensive discussion). An extreme case, “hyperbolic discounting,” gives rise to a wide range of time-inconsistent behavior and self-control problems, such as procrastination. More concretely, when individuals put a much higher value on the present and a much lower value on the future, they tend to defer all actions that have high short-run costs and long-run gains, such as saving or investing in education. When tomorrow comes, the same distinctio