metadata: authors: 0: author: Palacios,Miguel
docna: 0: docna: Options for financing lifelong learning
docty: Policy Research Working Paper
subtopic: Vocational & Technical Education,Vocational Education & Technical Training,Educational Sciences,Educational Populations,Lifelong Learning,Education for Development (superceded),Education For All
teratopic: Gender
abstracts: cdata!: How should lifelong learning be
            financed? The author attempts to answer the question by
            creating a framework for analyzing different education
            financing mechanisms in light of particular characteristics
            of lifelong learning. The framework compares the different
            financing alternatives on four dimensions: (1) who
            ultimately pays for the education, (2) who finances its
            immediate costs, (3) how payments are made, and (4) who
            collects the payments. The author uses specific
            characteristics of lifelong learning to determine which
            among the financing alternatives are most useful. The
            characteristics are that the individual should decide what
            and where to study, carry a significant part of the
            financial burden, and be encouraged to continue learning
            through all life stages. The author analyzes the financing
            alternatives according to who ultimately pays for the
            education. Hence, the alternatives are classified either as
            cost-recovery or cost-subsidization alternatives.
            Cost-recovery alternatives include traditional loans, a
            graduate tax, human capital contracts, and income-contingent
            loans. Subsidization alternatives are those in which the
            state directly subsidizes institutions or in which the state
            gives vouchers to students. The author concludes that
            combining income-contingent loans and human capital
            contracts with vouchers is the most efficient and equitable
            method for financing lifelong learning. The author discusses
            the role of governments and multilateral organizations in
            improving the financing of lifelong learning. He assesses
            shifting toward cost-recovery alternatives, focusing on
            collection of payments, and aiming for the involvement of
            private capital as key issues that should be addressed to
            ensure that lifelong learning will be available for all
            equitably and efficiently.
repnme: repnme: Options for financing lifelong learning
display_title: Options for financing lifelong learning
listing_relative_url: /research/2003/03/2176367/options-financing-lifelong-learning
topicv3: Education, Skills Development and Labor
            Market m1326135 1484,Vocational Education and Technical
            Training m1326570 1573,Vocational Education and Training m1326810 483,Education m1327048 470,Lifelong Learning m1327284 484
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Gender
origu: Education Team (HDNED)
no_of_pages: 36
author_keys: 0: author_key: 632814
model_extractions: **POLIcy** RESEARCH WORKING **PAPER** 2994

# **Abstract**

How should lifelong learning be financed? Palacios attempts to answer the question by creating a framework for analyzing different education financing mechanisms in light of particular characteristics of lifelong learning. The framework compares the different financing alternatives on four dimensions: (1) who ultimately pays for the education, (2) who finances **its** immediate costs, (3) how payments are made, and (4) who collects the payments. The author uses specific characteristics of lifelong learning to determine which among the **financing** alternatives are most useful. The characteristics are that the individual should decide what and where to study, carry a significant part of the financial burden, and be encouraged to continue learning through all **life** stages.

Palacios analyzes the financing alternatives according to who ultimately pays for the education. Hence, the alternatives are classified either as cost-recovery or costsubsidization alternatives. Cost-recovery alternatives include traditional loans, a graduate tax, human capital contracts, and income-contingent loans. Subsidization alternatives are those **in** which the state directly subsidizes institutions or in which the state gives vouchers to students. The author concludes that combining income-contingent loans and human capital contracts with vouchers is the most efficient and equitable method for financing lifelong learning.

The author discusses the role of governments and multilateral organizations in improving the financing of lifelong learning. He assesses shifting toward costrecovery alternatives, focusing on collection of payments, and **aiming** for the involvement of private capital as key issues that should be addressed to ensure that lifelong learning will be available for all equitably and efficiently.

This paper-a product of the Education Team, Human Development Network-is part of a larger effort in the network to support the analytic work **in** lifelong learning in the global knowledge economy. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact EnergyJames, room G8-104, telephone 202-473-1756, fax 202-522-3233, email address elames2@worldbank.org. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at palaciosmOl@darden.virginia.edu. March 2003. (30 pages)

> _The Policy Research Working Paper Series dissenPates the fedRgs of work in progress to encourage the exchange of ideas about development Issues. An objective of the series Is to get the findmngs out qtuncklv even if the presentations are less than fully polished. The papers carny the names of the authors and should be cited accordingly I7he findings, interpretatiois, and conclusions expressed in this_

> _paper are entirely those of the auithors. Tlyey do not necessarily represenit the viewo of the World Bank, its Executive Directors, or the cotuntrnes they represent_

Produced by the Research Advisory Staff
# **Options for Financing Lifelong Learning**

Miguel Palacios*

## Washington D.C.

*This paper was submitted to the Education Group, Human Development Network, at the World Bank by Miguel Palacios. Miguel Palacios is a Fellow at the Batten Institute, Darden Graduate School of Business Administration, University of Virginia.
Financing Lifelong Learning Miguel Palacios

# Options for Financing Lifelong Learning

|INTRODUCTION**..........................................................**<br>**4**|
|---|
|I.<br>AFRAMEWORKFORANALYZING ALTERNATIVESINFINANCING<br>LIFELONGLEARNING**..........................................................**<br>**4**|
|AGeneralFrameworkforAnalyzingEducation-FinancingPolicies..........................<br>4|
|PrinciplesforFinancingLifelongLearning...........................................................<br>9|
|II.<br>POLICYOPTIONSFORFINANCINGLIFELONG LEARNING**..................**12|
|Cost-RecoveryAlternatives............................................................<br>12|
|SubsidizationAlternatives............................................................<br>22|
|Combining Alternatives**to**Succeed.........................<br>...................................26|
|III.<br>CONCLUSIONS**.........................................................**<br>**26**|
|ThePreferredModel............................................................**26**|
|TheRolefor Governments............................................................<br>27|
|TheRoleoftheWorldBank............................................................<br>28|

3
Financing Lifelong Learning Miguel Palacios

## **Introduction**

Lifelong learning is an important policy topic for government. This assumption<sup>is based</sup> on the impact of additional training on economic growth and on income<sup>distribution,</sup> particularly in an age when previously acquired knowledge is depreciating<sup>fasterthan</sup> before. The relevant question for this paper is how to finance lifelong<sup>learningso that a</sup> country can benefit from the advantages of increasing its citizens' accumulation of human capital.

I have organized this paper with two main objectives in mind. The first<sup>objective is to</sup> create a framework for systematically analyzing alternatives for financing lifelong learning. The second objective is to analyze the main options that can<sup>be used to finance</sup> lifelong learning. The paper concludes with guidelines about the role that different players, including the World Bank, should play in financing lifelong learning<sup>in light of</sup> the available options.

# **1. A Framework for Analyzing Alternatives in Financing Lifelong Learning**

This section consists of two parts. The first part provides a framework for analyzing different schemes for financing education in general. The second part enunciates<sup>the</sup> principles that should prevail when designing mechanisms for financing education, particularly for lifelong learning.

### _A General Framework for Analyzing Education-Financing Policies_

It is convenient to develop a framework to better understand the differences between options for financing education. The following framework analyzes each instrument according to the following dimensions: (1) who ultimately pays for education,<sup>(2)who</sup> provides the financing, (3) who collects the payments, and (4) what financing<sup>mechanism</sup> is used. Each of them is explained in more detail below.

#### _Who ultimately pays for the financing_

This dimension of education financing asks who ends up paying for education<sup>costs over</sup> a lifetime. It should not be confused with who pays at the point of use,<sup>whichis partof</sup> the _initial_ financial arrangements. Major parties involved in the financing of<sup>education</sup> are: (1) the state, (2) employers, (3) other private entities, and (4) students and<sup>close</sup> relations.

Consider first arrangements where the state provides funds for education.<sup>This</sup> arrangement is not considered the best for two main reasons: (1) it is inequitable<sup>and (2)</sup> states simply do not have enough resources to cover the demand for education.

4
Financing Lifelong Learning Miguel Palacios Arrangements where the state provides most of the<sup>funds are inequitable becausethey use</sup> society's resources for an investment where the<sup>individualis the main beneficiary. The</sup> second limitation is a consequence of constrained<sup>national budgets combined with</sup> increasing demand for education services.

The way in which the state makes its contributions<sup>is relevantgiven the economic results</sup> it generates. There are two possibilities: (1) the state<sup>givesthe resourcestoinstitutions,</sup> also known as supply-side financing,<sup>or (2)thestate givesthe resourcesto students,also</sup> known as demand-side schemes.

Supply-side financing is the prevalent<sup>scheme today.The criteriaused to distribute</sup> resources among schools are often arbitrary and<sup>basedon historicaldevelopments,and</sup> often incorporate other performance-based<sup>criteria marginally.This state contribution,</sup> which often includes the running of institutions<sup>by thestate,and whichincludesthe idea</sup> that the state ultimately pays for education,<sup>has beenincreasingly recognizedas</sup> inefficient (see Ziderman, 1995). Consequently,<sup>proposalstoincrease thestate funding of</sup> educational institutions have concentrated<sup>on schemes wherestudents receive funding</sup> from the state, also known as demand-side<sup>schemes.</sup> Demand-side schemes are becoming the most popular<sup>alternative,and a wholerangeof</sup> arrangements has been devised to implement<sup>such (see Patrinos,1997).Vouchers,</sup> entitlements, tax credits and other similar<sup>instrumentsareexamplesof thiskind of</sup> funding. Less evident, but very relevant for this discussion,<sup>isthe</sup><sup>_subsidization of student_</sup> _loans,_ which should also be included in this category.

A second source of funding comes from employers.<sup>They benefitfrom having accessto</sup> an educated workforce and should thus be<sup>willingtocompensatefor this benefit.They</sup> can also benefit themselves by receiving knowledge<sup>fromeducationalinstitutions.</sup> Regarding the benefit of an educated workforce,<sup>Becker's(1993) analysisshowsthat</sup> employers will only be willing to cover<sup>thecostsof educationand trainingwhen the</sup> student acquires particular skills that cannot<sup>be transferableto other jobs.Conversely,</sup> they are not willing to pay for general,<sup>easily transferableskills.With respect to</sup> companies receiving knowledge, universities<sup>have been shiftingtowardsoffering</sup> additional services to business, a process<sup>called</sup><sup>_revenue diversification,_but fees from</sup> these services remain insufficient to<sup>cover educationcosts.</sup> A third funding source is the "charity" of<sup>privateentities, suchas NGOsand religious</sup> organizations. These entities invest resources<sup>in education withoutseekinga monetary</sup> return on their investment. They constitute many of<sup>thegrants availablefor students and</sup> are usually directed at students in need of<sup>financialaid. However,the resourcesthat</sup> society can spend on education without<sup>anyexpected returnarelimited,and these</sup> organizations will never be able to<sup>provideall the funding requiredto meet the increasing</sup> demand for higher education and lifelong<sup>training.</sup> The fourth source of funding is the student.<sup>Modern economicliterature(startingwith</sup> Friedman (1955) and Becker (1993)) recognizes<sup>thestudentas the main beneficiaryof</sup> _5_
Financing Lifelong Learming Miguel Palacios education and training, and also as the only party that can eventually contribute<sup>in a</sup> significant way to covering education costs. It is also recognized that having<sup>the student</sup> pay for education costs is equitable and efficient. This arrangement is equitable<sup>because</sup> the student is the greatest beneficiary of additional training received; it is efficient because students then have an economic incentive to shop around for the<sup>best educational</sup> institution to spend their money on, creating competition among schools.

Several authors (see for instance Barr, 2001) point out the impossibility of<sup>arrivingat a</sup> "perfect" combination among these sources of funding, particularly with regard to the proportion between state and student funding. On one hand, theory suggests<sup>that a system</sup> completely state funded (no student fees) is not equitable. On the other hand,<sup>some</sup> funding is required to attract certain groups who have been systematically marginalized from education opportunities. Any solution will have to consider the constraints of<sup>the</sup> state for funding education but must not deny its important role in promoting<sup>equal</sup> opportunities in education. Externalities are also a reason why government funding<sup>would</sup> be required. However, there is no conclusive evidence on the magnitude of<sup>externalities,</sup> particularly from lifelong learning, and they are considered to be relatively<sup>small. Thus,</sup> public funding of lifelong learning to address externalities will only be considered marginally in this paper.

# _Who Finances Education_

Whereas the previous section was concerned with who ultimately pays for<sup>education,this</sup> section is concerned with who provides the immediate funding for education at the point of use. This question is relevant because it is current resources, not future<sup>ones, which</sup> allow institutions to function on an everyday basis. Thus, _the principle that students should pay for education should be combined with the principle that education_<sup>_should not_</sup> _require payments at the point of use._ If payments are demanded from the student, only students who have resources before studying will be able to pay the costs of<sup>the</sup> investment. Upfront financing of education is key to making students pay for education without harming access to disadvantaged groups.' The major sources for the<sup>financingof</sup> education are (1) the private financial sector, (2) the state, and (3) students.

The first alternative, private sector financing, should enable investment in education in an efficient market. Private financing is not limited to financial institutions,<sup>though they are</sup> the natural providers of capital. Other possibilities are the educational institutions themselves and employers. Three examples of instruments that they can use are<sup>private</sup> loans, Human Capital Contracts and income-contingent loans.<sup>2</sup> Other instruments include risk-sharing alternatives that might make a financial scheme viable. Unfortunately, the education market is not efficient, and thus relying on the private sector alone to<sup>provide</sup>

> ' This does not mean that perfect financing would solve the issue of access to education. In fact, socioeconomic groups systematically misinformed regarding the value of<sup>investments in educationwill</sup> tend to under-invest in it. Other arrangements besides perfect financing schemes<sup>are requiredto attract</sup> those sectors of the population.

> 2 The definition and characteristics of these instruments are discussed in the<sup>second section of this paper.</sup>

6
Financing Lifelong Learning Miguel Palacios the funds for education is not feasible,<sup>atleast whilethe inefficiencies are not addressed. 3</sup> However, the involvement of private<sup>sectorfinancingin education, evenif only partially,</sup> is fundamental for its expansion.

The second source of financing is<sup>the state.Under thisarrangementthe state providesthe</sup> resources initially, but expects the<sup>studentto ultimately pay. The most prominent</sup> examples are public student loans,<sup>includingsomeincome-contingentloans,and the</sup> graduate tax. The use of the state<sup>forfinancingeducation isa response tothe lack of</sup> private funding for education. However,<sup>current budgetary constraintsdo not allow</sup> governments to meet the increased<sup>demandsfor higher and continuingeducation.</sup> The third altemative for financing<sup>educationis the student, and asanextension, hisor her</sup> family. This alternative is the only<sup>oneavailablewhenthe othersare not, denyingaccess</sup> to higher and continuing education<sup>to the studentwho does not have theresourcesto pay</sup> for it.

# _Financing Mechanism_

The financing arrangement between<sup>the funding agency(state, private,etc.)and the</sup> individual can take many different<sup>forms.The followingdescriptionoffers anoverview</sup> of the major alternatives available.

Consider loans first. Although<sup>they are the most straightforward mechanismfor making</sup> capital available, they are not a good<sup>alternative forfinancing education.The most</sup> common type, also called "mortgage-type",<sup>expectsstudents to pay a fixedamounteach</sup> period, typically per month, for a<sup>certain amountof time.The main problems with this</sup> kind of loan are that it does not adapt<sup>to the needs of thestudentand leaveslenderswith</sup> little protection against default.

One way to adapt loans to the<sup>needsof studentsisto match requiredpaymentswith the</sup> student's capacity to pay. The simplest<sup>solutionis to createa schedulein whichpayments</sup> increase according to how a student's<sup>incomeissupposed to increase.This particular</sup> kind of loan is called a graduated<sup>loan.The next step in making loans moreaccessibleto</sup> students is to provide additional<sup>flexibility to takeinto accountspecialcircumstances</sup> such as unemployment, further<sup>training,or periods of low-income.Ideally, payments</sup> could be made at the discretion of<sup>the student,almostlike creditcard payments.</sup> However, flexibility requires a price<sup>and presumably a moreflexibleinstrument would</sup> become more expensive for students.<sup>Also, complete flexibility might not be realisticas</sup> this may encourage defaults, making<sup>thesystem unsustainable.Nevertheless,additional</sup> flexibility as a solution for private<sup>education financinghas been identifiedas key to</sup> improving the options for students.

Friedman (1955) suggested equity<sup>financing, the method used for investing in high-risk</sup> investments, as a possible approach<sup>to financing education. This arrangement</sup> 7
Financing Lifelong Learning Miguel Palacios compensates investors by allowing them a possibility<sup>of higher returnsfor the higher risk</sup> they take on when financing students. This kind of<sup>financing woulddemand froma</sup> student a percentage of his or her income during<sup>a specificperiod of time.Such an</sup> instrument is a Human Capital Contract.<sup>4</sup> Finally, an intermediate approach between loans<sup>and equity-like investmentshas been</sup> gaining popularity since the 1970s: income-contingent<sup>loans. Theseloans combinethe</sup> flexibility of Human Capital Contracts with the<sup>"fixed-obligation"characteristicof loans.</sup> This mechanism, as well as the other ones, will be<sup>studiedin further detailin this</sup> document.

# _Who Collects Payments_

The experience of payment collections in countries<sup>with publicly collected income-</sup> contingent loans, such as in Australia, and in<sup>countries where privateentitlementsare</sup> collected along with taxes, such as the private pension<sup>fundin Chile,open up the</sup> possibility for combining different kinds of financing<sup>with two main collectionmethods:</sup> private and public. Private collection of payments<sup>iswhat banks use to collecttheir debts.</sup> Public collection uses existing institutions, such<sup>as taxing authorities,to collect education</sup> payments.

The distinction between private and public collection<sup>of paymentsis relevant,since it</sup> requires very different degrees of participation from<sup>the state.In the caseof private</sup> collection, the state need only enforce contracts. In<sup>contrast, in the case of public</sup> collection the state enforces law into its collection<sup>mechanismand also usesits tax-</sup> collection agency to enforce payments. Public collection<sup>of paymentsis relevant because</sup> it provides a cost-effective way of collecting payments<sup>from students, using the already</sup> existing state machinery.<sup>5</sup>

# _Locating Alternatives According to the Framework_

The previous discussion is summarized in the following<sup>table.Notice thatmost financing</sup> schemes are actually a combination of these instruments.<sup>6</sup>

> 4Human Capital Contracts and a related instrument,<sup>theGraduate Tax,are analyzedinthe second part of</sup> this paper.

> _5_ This is the reason why Barr (2001) calls it to<sup>'piggy-back'on the state.</sup>

> **6** All the mechanisms that the author knows of<sup>arean"implicit" combinationof instruments.In the simplest</sup> case, a loan offered with a subsidized interest rate<sup>isa combinationof a loan anda subsidyfrom the state,a</sup> voucher proportional to the value of the loan. It<sup>is worthwhile to mentionsome benefits that can arise from</sup> stating explicitly the instruments embedded in a<sup>financial mechanism:(1)easieraccess to privatemarkets,</sup> since the flows can be understood easier, (2) the risk<sup>embedded bythe different instrumentscan be</sup> separated and assigned to different parties,<sup>and (3)presumably instrumentsare easier to understand by</sup> policymakers as well as consumers.

8
Financing Lifelong Learning Miguel Palacios

**Table 1: Main Instruments for Financing Education**

|WhoUltimately<br>**Pays**|Who<br>**Finances?**|**Collection**|**Financing**<br>**Mechanism**|**Instrument**<br>|
|---|---|---|---|---|
||**Student**|**N/A**|N/A|EducationSavingsAccounts|
||||Fixed|PrivateLoan<br>|
|||**Private**|Combined|PrivateIncomeContingentLoan|
||**Private**|**-**|Variable|Human CapitalContract|
||||Fixed||
|||**Public**|Combined|Institutional Income-ContingentLoan|
|**Student**|||Variable|InstitutionalHumanCapital Contracts|
||||Fixed|PrivatelyCollectedPublicLoan|
|||**Private**|Combined||
||**Public**||Variable||
||||Fixed|PublicLoan|
|||Public|Combined|PublicIncome-ContinentLoan|
||||Variable|GraduateTax|
|**Employer**|**Public**|**Public**|Variable|Employeesgraduatetax<br>|
||||N/A|DirectUniversityFunding<br>|
||||N/A|Vouchersandentitlements|
|**(tax-payer)**|**N/A**|**N/A**|N/A<br>|Grants<br>|
||||N/A|Interestsubsidyonloans|
|||______<br>_<br>_N/A|_|TaxCredits|

Blank spaces denote possibilities that have not been proposed or implemented as a<sup>policy altemative.</sup> Although beyond the scope of this document, there are several<sup>altemativesthat</sup> governments might consider in the future to attract private capital to provide<sup>government</sup> with the resources needed to offer public funding of education. One such alternative consists in having government sell the rights to the proceeds from<sup>additionalinvestments</sup> in education. For example, governments could "sell" part of the taxes<sup>receivedfroma</sup> particular individual. These possibilities are not considered here.

# _Principles for Financing Lifelong Learning_

To analyze the various options available for financing lifelong learning, it is good<sup>to</sup> discuss first what makes a particular option suitable. The following paragraphs describe the requirements that a financial aid program should satisfy. The general requirements<sup>for</sup> any level of education are studied first, and then the particular requirements of lifelong learning are considered.

9
Financing Lifelong Learning Miguel Palacios

# _General Requirements of an Education_<sup>_FinancingScheme_</sup>

Options for financing any particular kind of<sup>training should take intoaccount certain</sup> considerations, the most important being<sup>the following:(1)equitableaccess,(2) impact</sup> on the education market, and (3) impact on<sup>the labor market.</sup> First, a solution for financing education should<sup>aim at making educationaccessibleto</sup> anybody who has the capacity and will<sup>to undergo additional training.Any other</sup> arrangement, such as one that might<sup>detract individualswith low-incomesfrom</sup> participating, would create a situation in<sup>which only better-off individualscan continue to</sup> improve their skills (a situation which<sup>isobservedtoday).Such an arrangement would not</sup> be equitable for those who want to increase<sup>their skills but do not have the resources.</sup> Second, different policies have different<sup>impactson the behaviorof the educationmarket.</sup> Following the classic economic model, policies<sup>for financingeducation should aim to</sup> enhance the choices available to potential<sup>students,increase the informationavailable to</sup> help them decide on what course to take and<sup>whatinstitutions to attend,andincrease</sup> competition between educational institutions.

Finally, the impact of a particular policy<sup>on the labor marketshould be takeninto</sup> account, since the performance of the economy<sup>is oneof the reasons why educationis</sup> considered important. The impact of different<sup>schemes can bestudied by analyzing the</sup> effect that particular repayment methods<sup>haveon the decisionsindividualsmake when</sup> deciding where to work. For instance,<sup>Oosterbeek(1998)discusses the possible effect</sup> that income-contingent payments might have<sup>whenan individualchooseswhether to</sup> work or not, and what levels of income to<sup>seek.He concludesthat these arrangements</sup> may produce a disincentive for the individual<sup>towork. The possiblewelfarecosts that</sup> this generates should thus be considered<sup>whenevaluatingthe use of income-contingent</sup> payments.

## _Lifelong Leaming Requirements_

At this point it is relevant to ask why<sup>thefinancingof lifelong learningshould be</sup> different from that of other kinds of education.<sup>Lifelong learning is defined here as the</sup> learning that takes place after primary,<sup>secondaryand tertiary levels, even if thestudent</sup> did not actually go through these levels.<sup>The differencesbetweenthesestages of learning</sup> are the foundation for the following principles:<sup>first,lifelong learningshould bemostly</sup> privately financed and pursued; second,<sup>some kind of government interventionand</sup> financial support is required to target<sup>marginalizedgroupsand to take accountof</sup> externalities; and third, the _actual provision_<sup>of lifelong learningshould remainin private</sup> enterprises. Each of these principles is discussed<sup>below.</sup> Young students are constantly being prepared<sup>tolive in asociety with certainshared</sup> values and beliefs (what Friedman (1955)<sup>calls "education for citizenship").At basic</sup> levels of education, students are given<sup>a foundation of basic knowledge that willallow</sup> them to join society. On the other hand,<sup>grown-up studentsare learning much more</sup> specific skills that build on the foundations<sup>they learnedearlier (Friedman(1955) refers</sup> 10
Financing Lifelong Learning Miguel Palacios to this as "vocational training"). Likewise, Oosterbeek (1998) divides learning<sup>intotwo</sup> stages: an initial learning stage where individuals acquire the foundations to<sup>continue</sup> learning throughout their lives, and a second stage, adult learning, where individuals use their foundations to learn new skills.

According to Friedman, the differences between "education for citizenship" and "vocational training" call for different policies from the state because the former kind<sup>has</sup> huge externalities, while the latter, in spite of probably having some externalities,<sup>has</sup> mainly personal benefits. Because of the large personal benefits involved in "vocational training" relative to the externalities, the reasons for government subsidizing and running "vocational training" institutions are small. Education at this level becomes a private matter. Notice that Friedman referred to higher education when he was speaking<sup>of</sup> "vocational training", but his analysis is even more valid for post-higher-education learning. Thus, following Friedman's logic, the individual who is undertaking lifelong learning should finance it mostly by himself.<sup>7</sup> The previous paragraph does not rule out government funding of lifelong learning. In fact, even though training at advanced ages primarily benefits the individual, government intervention is desirable for equity considerations. There are certain socioeconomic groups, particularly low-income ones, which are systematically marginalized from educational opportunities, and thus require targeted efforts from government. For example, government can target individuals that were marginalized from the traditional levels of education. These individuals can get involved in lifelong learning opportunities as a second chance to improve their skills and earnings capacity. Therefore, a second principle for lifelong learning is that some government funding is required to ensure equal access.<sup>8</sup> The third principle regarding the financing of lifelong learning relates to the<sup>character of</sup> government intervention in this market. Because lifelong learning encompasses<sup>such a</sup> wide variety of areas, including learning outside formal education settings, and<sup>because</sup> of the different circumstances each individual faces in life, it is very difficult for government to try to administer the provision of lifelong training.<sup>9</sup> Thus, the intervention of the state in lifelong learning is best when it offers regulatory supervision<sup>(such as</sup> improving the amount and quality of information available regarding different<sup>courses</sup> and institutions). This operating principle makes the individual responsible for<sup>pursuing</sup> additional training, and for choosing how and where to do it, while government<sup>only</sup> supports and informs the individual's decision.

To conclude, a proposal that seeks to promote lifelong learning should not discriminate against particular kinds of learning, and against particular ages or periods of<sup>life for</sup> 7 An alternative is that employers finance education. However, Becker's (1993) division between general and specific skills predicts that employers will only be willing to finance what Becker defines<sup>as specific</sup> training.

**8** This does not rule out the possibility of using other methods to ensure equal access. **9** As with the distinction between "education for citizenship" and "vocational<sup>training",Friedman offers</sup> this argument to reject the direct provision of almost any kind of education<sup>by government.</sup>
Financing Lifelong Learning Miguel Palacios which it should be undertaken. A proposal that favors<sup>age groups, or experiencegroups,</sup> will defeat the purpose of enhancing opportunities for<sup>additionaltraining throughouta</sup> lifetime.

In summary, the following combination of principles<sup>should be considered when</sup> designing policies for financing lifelong leaming:<sup>Io</sup>

1. The individual should be responsible for<sup>deciding whatadditionaltraining to</sup> pursue and when to continue training.

2. The individual should also carry most of the financial<sup>burden.</sup> 3. The system should be equitable. Government<sup>can usesubsidies to attractstudents</sup> from marginalized backgrounds.

4. Government has an important role regulating<sup>the provisionof education.</sup> _5._ The system should promote efficiency in the<sup>educationmarket.</sup> 6. The system should promote efficiency in the labor<sup>market.</sup> 7. Finally, the system should encourage learning<sup>throughout alllife's stages.</sup>

# **II. Policy Options for Financing Lifelong**<sup>**Learning**</sup>

After enunciating the principles that a system<sup>for financing lifelong learningshould</sup> follow and exploring the framework through which<sup>differentpolicieswill be analyzed,</sup> this section analyzes a wide variety of instruments for financing<sup>educationand providesa</sup> recommendation as to the feasibility of each one<sup>in light of theprinciplesdiscussedin the</sup> previous section.

Although they are usually implemented together, two<sup>distinctkinds of alternativesare</sup> presented: (1) those where the student is expected to<sup>pay for atleast part of the costof</sup> education, also known as _cost-recovery_ schemes,<sup>and(2) thosewheregovernmentpays</sup> for education. This division corresponds to the fundamental<sup>difference in objectives</sup> between these alternatives. One focuses on the mechanism<sup>usedto makestudents pay for</sup> their education and the other focuses on the best way<sup>in which government supportcan</sup> be delivered to students to promote lifelong learning. Let's<sup>considerthe</sup><sup>_cost-recovery_</sup> schemes first.

## _Cost-Recovery Alternatives_

Cost-recovery schemes expect that the student pays<sup>forat least part of the cost of</sup> education. This approach is commonly advocated in economics-of-education<sup>literature</sup> (see for example Barr (2001), Johnstone (2001 a)) on<sup>the groundsof efficiency and</sup> equity. Cost-recovery is efficient because it leaves the<sup>state and educationalinstitutions</sup>

**10** For another set of criteria for evaluating financing<sup>mechanisms,seeTimmermann's"Financing</sup> Mechanisms" in Levin (1983). Tinimermann mentions<sup>(1) encouragingrecurrence,(2) increasing</sup> efficiency, (3) encouraging innovations, (4) encouraging marketable<sup>skills, (5) encouragingintegration,(6)</sup> encouraging individual choice and personal development,<sup>(7) equality of educational opportunity,(8) social</sup> and economic equity, and (9) democratization of education<sup>and work.</sup>

12
Financing Lifelong Learning Miguel Palacios with more resources to invest in education, thus decreasing<sup>the waste generated by under-</sup> investment in human capital. Cost-recovery is equitable<sup>becauseit asksthose who benefit</sup> from education to pay for it. Individuals are the primary beneficiaries<sup>of education,</sup> enjoying higher average earnings after graduation than they<sup>wouldearnotherwise.1'On</sup> the other hand, cost-recovery strategies always raise concerns<sup>regarding the potential</sup> harm to access they can cause. The concern is that if cost-recovery<sup>schemesare not</sup> introduced carefully, they can marginalize low-income students<sup>from the possibilityof</sup> obtaining additional education.

The following section describes four cost-recovery instruments:<sup>(1)traditionalloans,(2)</sup> Human Capital Contracts (HCCs), (3) graduate tax and (4) income-contingent<sup>loans.As</sup> each instrument is explored, its desirability is studied in<sup>lightof the considerations</sup> introduced in the first section.

# _Traditional Loans_

Traditional "mortgage-type" loans provide the easiest<sup>arrangementfor financing</sup> education. They operate in the same way as other loans, requiring<sup>fixedpaymentsfor a</sup> specific period of time. The amount that students have<sup>to pay eachperiod,typicallyeach</sup> month, depends on the total amount borrowed, the interest<sup>rate,and the repayment</sup> period. Because this kind of instrument is widely used<sup>and understood,no furtherdetails</sup> will be given here.'<sup>2</sup>

### Advantages:

The main advantages of traditional mortgage-type loans<sup>areits simplicity and the existing</sup> knowledge about them. Traditional "mortgage-type" loans are<sup>probablythe most basic</sup> financial instrument used to satisfy cash needs. They are<sup>also widelyused and</sup> understood. Thus, implementing "mortgage-type" loans<sup>is probablyrelativelyeasy froma</sup> policymaker's point of view. From an investment point of view,<sup>the knowledgethat</sup> investors have of these loans makes them easy to evaluate.

## Weaknesses:

Unfortunately, "mortgage-type" loans have several<sup>weaknesseswhenused forfinancing</sup> education. First, education is an intangible asset that<sup>cannot be used ascollateral,thus the</sup> risk for the lender increases. The absence of collateral typically<sup>results in "mortgage-</sup> type" loans being offered only to families who have<sup>enough assets toserveas collateral,</sup> precisely those who need financial aid the least. Second, the<sup>returns toinvestmentsin</sup> education are wide, with some obtaining high returns<sup>while othersstruggling to maintain</sup> an income level high enough to pay the debt. Students<sup>cannot know withcertainty before</sup> investing in their education that their investment will allow<sup>them to repay their debt</sup> The inequity of government subsidization is higher the<sup>furtherawaysocietyis fromuniversal</sup> participation in education.

2 For detail on policy options for using these loans to finance<sup>education, see Woodhall(1987).For a</sup> general overview of "mortgage-type" loans, their characteristics<sup>and valuation,see Fabozzi(1996).</sup> 13
Financing Lifelong Learning Miguel Palacios comfortably. This problem is exasperated by the inflexibility of the payment schedule of traditional loans.

As an alternative to inflexible payments, a variation of the traditional "mortgage-type" loans, called "graduated" loans, exists. Graduated loans adjust payments to the expected earnings of the student once he or she joins the workforce, so that the relative weight of debt payments as a percentage of total income remains more or less constant. Although these loans are one step further in accommodating students, they adjust to _the average_ individual, but do not solve the particular needs of particular students. Thus, they still fail to overcome the criticism ascribed to traditional "mortgage-type" loans.

The poor collection rate on traditional loans, not surprisingly, is a result of the absence of collateral and the risk the student faces. The collection of traditional student loans has been done by different entities: the state, private banks and universities. The track record of collection of the state and universities has not been satisfactory (see Ziderman (1995)). For banks, on the other hand, pursuing defaulters on student loans is expensive relative to the total amount of loans. As a result, the cost-recovery on traditional loans has been dismal (not that other alternatives are much better). Possible ways to improve results, though not perfect, include government collection through other pre-existing collection agencies and govermment-backed loans.

# _Human Capital Contracts_

Human Capital Contracts have been proposed as a viable alternative for financing education in recent years. Originally proposed as a financial alternative for education by Milton Friedman (1945 and 1955), the idea behind Human Capital Contracts provided the basis for the graduate tax and for income-contingent loans.'<sup>3</sup> During the 1960s and 1970s these two variations became more popular, and Human Capital Contracts were not considered again until the early 1990s as a viable option.

The development of financial markets during the last two decades of the twentieth century created favorable conditions for private initiatives to invest in Human Capital. Among the pioneers in the trend are The Pullman Group, which is well known for issuing the "Bowie Bonds", and more recently, MyRichUncle, a company that started financing students through Human Capital Contracts during 2001.

A Human Capital Contract (HCC) is a contract in which a student commits part of his future earnings for a fixed period of time in exchange for capital for financing education. The main parameters required to design a Human Capital Contracts are the percentage of income and the repayment period. The instrument works best when market forces determine the parameters of the contract.

**13** The term "Human Capital Contract" comes, to the author's knowledge, from Roy Chapman. Mr. Chapman launched a proposal to implement Human Capital Contracts in the mid 1 990s, but because he believes that the laws in the United States still do not protect investors who invest in Human Capital Contracts, he did not implement the project. See "Colsobs" in _Forbes,_ November **4th,** 1996.

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Financing Lifelong Learning Miguel Palacios Advantages: HCCs have at least two desirable characteristics that make them<sup>superior to"mortgage-</sup> type" loans for financing education: (1) they decrease the risk of<sup>the investment to the</sup> student, (2) they are equitable, and (3) they can offer a measure of<sup>the expected valueof</sup> education, becoming a source of information for students and<sup>regulatingauthorities.'4</sup> HCCs decrease the risk of the investment for students by adjusting<sup>the paymentsthey</sup> would have to make according to the amount they earn after<sup>completingtheir education.</sup> If a student's investment in education does not result in high<sup>earningsafterwards, the</sup> required payments for education financing are small. Conversely,<sup>if a studentis able to</sup> earn high incomes after completing education, payments<sup>are much higher. On average,</sup> those students who can pay because of the high earnings they<sup>obtainas a resultof their</sup> education cover the cost not covered by those who do not obtain<sup>high earnings.Further,</sup> HCCs adjust favorably as a student's income decreases, avoiding<sup>financialdistress for the</sup> student and decreasing the probability of default.

Because each student ends up paying according to his own capacity to<sup>pay,Human</sup> Capital Contracts are equitable from a lifelong perspective.<sup>Oosterbeek (1998) describes</sup> this characteristic (though he is referring to income-contingent loans),<sup>as promoting</sup> "dynamic" equity. An arrangement satisfies a concept of dynamic<sup>equityif the amountof</sup> aid given to different students depends on their capacity<sup>to pay during their lifetime.It is</sup> contrasted by the concept of static equity, where the amount<sup>that an individualhas to pay</sup> is determined by his earnings capacity at one point<sup>in time.An exampleof the use of</sup> static equity principles can be seen in traditional education financing<sup>schemes,where the</sup> capacity of an individual to pay upon starting his or her education<sup>isthe relevant factor</sup> for deciding how much aid he or she should receive..

Finally, in a system where the percentage of income that students<sup>commitisfreely set by</sup> a market, the percentage of income required by investors<sup>revealsthe expected valueof</sup> earnings for individuals who complete their studies at particular institutions<sup>and in</sup> particular fields of study. This information increases the competition<sup>betweenschoolsas</sup> their cost relative to future benefits becomes transparent. Under<sup>a systemwhereHCCs</sup> are functioning, students have an incentive to go to the school<sup>where they commit the</sup> lowest percentage of income, not to the cheapest place. As a result,<sup>HCCs will</sup> presumably apply pressure on educational institutions to improve the<sup>value of the</sup> cost/benefit relation offered to students.

Weaknesses and Obstacles to Implementation: Human Capital Contracts have several implementation limitations.<sup>The most relevantare</sup> (1) the capacity to determine information accurately<sup>from theindividual,(2)the</sup> 14 As will be discussed below, some of these advantages are<sup>not exclusiveof HCCs, butare a common</sup> theme for income-contingent repayment schemes.

15
Financing Lifelong Learning Miguel Palacios phenomenon of adverse selection<sup>and(3)the negative effect they can have in the labor</sup> market.

The capacity of the investor to<sup>determinea student'sincome and the capacity of the</sup> investor to collect payments<sup>fromthe student are extremely relevantforthe successof</sup> HCCs in a country. A student's<sup>income can be estimatedif there is a well-developed tax-</sup> collection agency to which citizens<sup>report accurateincomeinformationor if a social</sup> insurance or pension fund system<sup>exists that uses incomeinformation to determine</sup> benefits for individuals. In<sup>particular,whena significantamount of graduatesend up</sup> working for government, the<sup>problemof determining income isgreatly reduced.' 5Still,</sup> students have an incentive to<sup>hide theirincomein order to decreasetheir payments,and</sup> they are likely to be successful<sup>tosome extent.</sup> To aid investors, the tax-collection<sup>agency can collect paymentsfor investors.Wherea</sup> developed tax-collection system<sup>alreadyexists, the marginalcost of collectingpayments</sup> on Human Capital Contracts<sup>should presumably below.Given the Australianexperience</sup> with income-contingent loans<sup>(see Chapman (1997)),which requiresthesame operations</sup> from tax-collection agencies,<sup>costscan be around1% of theamount collected. This</sup> arrangement, which I call _Institutional_<sup>_Human Capital Contracts_(SeePalacios(2001)),</sup> would operate in much the same<sup>way that private pension funds collect money in</sup> countries such as Chile, with<sup>the differencebeing that the state would deposit payments</sup> in investors' accounts, rather<sup>thanin individuals'accounts.</sup> The next issue related to determining<sup>a student's income and collectingpaymentsfrom</sup> students has to do with the<sup>proportion of graduateswho leave the country.Presumably,</sup> the feasibility of determining<sup>incomeandcollecting paymentsdecreaseswhen students</sup> leave the country. To address<sup>this problem, certain conditions can be placedon the</sup> contract in case emigration<sup>takes place,such as demandingan immediatepayment.'The</sup> best alternative for facing this<sup>problem in thelong run is the establishmentof</sup> multinational treaties that allow<sup>foreigncountriesto collectpaymentsfromstudentswho</sup> emigrate. Barr (2001) even suggests<sup>that entities like the World Bank couldaid in the</sup> creation and operation of such<sup>a system.A system that solves theproblem of collecting</sup> payments from students who<sup>emigratewould allow studentsto benefit from higher</sup> foreign income and would benefit<sup>the countrieswhere thestudentengagedin the HCCs</sup> by returning part of the extra<sup>value derived fromthe studentworking abroad.</sup> The second important obstacle<sup>to implementing HCCs is adverseselection.Adverse</sup> selection occurs when investors<sup>are unableto discriminate betweenfuture highearners</sup> and low earners.<sup>17</sup> If the investor<sup>is unable to discriminate, future highearners willfeel</sup> that a HCC is very expensive,<sup>and futurelow-earnerswillsee it as cheap.As a result,</sup> students who see themselves<sup>with high future earnings willnot join thesystem and</sup>

> 5 For example, Colclough (1990)<sup>statesthat65%of Botswana's graduateswork for government.</sup> **16** Several loan programs in<sup>fact do this.For example,Colombia's Colfuturoand Venezuela's</sup> FondoAyachucho loans require<sup>such conditionsfrom students.</sup>

> 17 This occurs if there is asyrnmetric<sup>information.The processexplainedhere closely resembles Ackerlof's</sup> famous exposition (1970) in<sup>"The market for the Lemons".</sup>

16
Financing Lifelong Learning Miguel Palacios students who expect to have low future earnings will eagerly join. To compensate for the low payments that low-earning individuals would make to HCCs, investors raise the percentage of income they ask from students, which further worsens the problem. Eventually, the market for HCCs breaks down and its benefits become unavailable for everyone.

There are several measures that can be taken to avoid adverse selection. One of them is to offer different rates to different individuals. Assuming that investors _can_ discriminate between future high earners and low earners, they can offer different rates to them. As a result, both future high earners and low earners perceive that the amount that they have to commit of their future earnings has a fair value and are willing to join the system. This is analogous to what insurance companies do to discriminate between high-risk and lowrisk individuals. By offering different premiums to different individuals, both high-risk and low-risk ones feel that the deal they are being offered is fair and take an insurance policy. If the premium was the same for everybody, low-risk individuals would not join, increasing overall risk to the company.

> The founders of the only company that was offering HCCs when this document was being prepared, MyRichUncle, state that through their proprietary valuation model they

> are able to discriminate between potential high-earners and low-earners and in doing so they address the problem of adverse selection. As more students are financed through

> HCCs, more information will be available that will allow investors to discriminate between different kinds of students. Thus the possibility of adverse selection decreases. Other solutions for avoiding adverse selection are discussed in the next sections, which study graduate taxes and income-contingent loans.

> The third argument that has been brought forward against instruments that take away a

> percentage of income from graduates is the disincentive it produces for working. Because individuals perceive a lower income for whatever job they accept, they have a lower incentive to search high paying jobs and a lower overall incentive to work. The macroeconomic consequence is a lower output and growth, since human capital would not be placed at its best use. The question here is the magnitude of social loss from this disincentive to work and the magnitude of the social gain of reducing risk for students.

> The answer to this question can only be answered with additional research.

# _Graduate Tax_

After the initial proposal of HCCs, one of the variations proposed during the 1960s and during the 1980s was the concept of the graduate tax. A graduate tax would "tax" each graduate for having attended college. Thus, each student would end up paying a percentage of their income throughout their productive life. Although the idea of a graduate tax is based on the same principles on which HCCs are based, there are some important differences illustrated in Table 2.

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Financing Lifelong Learning Miguel Palacios

**Table 2: Contrast Between HCCs and Graduate Tax**

|**Characteristic**|**GraduateTax**|**Human CapitalContract**|
|---|---|---|
|**Percentageofincomedeterminedby**|Government|Investors.Presumably differentfor<br>eachstudent.|
|**Studentsjoin**|Involuntarily<br>7|Voluntarily|
|**Termofthecontract**|Wholeproductivelife|Fixed periodoftime|

Advantages: The graduate tax shares with HCCs the advantages of (1) lowering the risk that students face in their lifelong earnings, (2) lowering risk of defaulting on payments due to financial distress, and (3) the satisfaction of dynamic equity.

The graduate tax is also very simple. Individuals just need a code to show that they are graduates and the tax-collection authorities use it during the whole life of the individual to retain the corresponding tax. Unlike the operations needed to determine if a student has repaid a loan entirely or if their repayment period under a HCC has concluded, the graduate tax is always collected.

A third advantage is the relationship that exists between the life of the investment in education and the payments that the individual has to make after the financing of that investment. In theory, the best financial scheme will equate the payments made for financing an investment with the productive life of the investment. In contrast, very long repayment periods can produce negative consequences such as the perception of servitude or unfairness for having to make payments for such long periods. Further, most developing countries do not have developed financial markets where this kind of longterm obligation can be established.

The advantage of being able to tax individuals over their whole productive life decreases in importance, or might actually become a disadvantage, if the value of the additional knowledge that the individual is acquiring does not last a lifetime, a characteristic of skills in this age. Since one of the principles behind the need for lifelong learning is the fast depreciation of new skills, a graduate tax imposed on the individual for a determined period of time, rather than a lifetime, would avoid the problem, though it would make the instrument more complicated.

Finally, because a graduate tax would be imposed on all graduates, this kind of financing would suffer less adverse selection than HCCs. In contrast with HCCs, where students who see in themselves a high-income potential might choose to not finance their education using that method, potentially high-income earners do not have a choice but to pay the graduate tax. This guarantees that the amounts collected through the graduate tax do resemble the average income of graduates, and not just the average income of the lowest-income earners who joined the system. However, in spite of the graduate tax being mandatory, adverse selection will not be eliminated completely. This will be explained in the following section.

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Financing Lifelong Learning Miguel Palacios Weaknesses and Obstacles to Implementation: A graduate tax also shares some of the disadvantages of HCCs. For the graduate tax to work, a state-collection agency has to have the ability to determine graduates' incomes and to collect the tax from them. In the absence of a state-collection agency, a national insurance system, or a social security system can aid in determining income. However, without any of these, the amount that can be recovered might be very low.

A graduate tax cannot be levied when the individual emigrates. In this respect, a graduate tax behaves even worse than a HCC, since in the case of the latter an investor theoretically still has a claim on a percentage of an individual's income regardless of the particular place where the individual is residing. This is not true in the case of a tax.'<sup>8</sup> The tax would worsen the situation by giving an incentive to those who have higher marginal taxes, the highly skilled, to emigrate, creating a brain drain. A possible solution is an agreement between nations to levy or withhold the amount of the tax and to pay it to the country of origin. This would enable the individual to enjoy the benefits of higher salaries abroad and would return part of that value to the country of origin.

> A third problem with the graduate tax is the adverse selection that it generates among

> individuals with different levels of ability. In particular, a graduate tax taxes all earnings

> equally, without discriminating between earnings due to additional education and those due to other factors, such as ability or occupation industry. As a result, the graduate tax creates a disincentive to pursue additional training in those individuals who would have

> obtained high earnings without education. The only way to avoid this is by differentiating among students to tax only the returns obtained because of the additional education. In

> essence that is what investors do in HCCs when they offer different students different conditions.

A fourth drawback of the graduate tax is its inability to create immediate resources for funding education. While other alternatives might be attractive enough such that private capital might be willing to invest in education from the beginning, the graduate tax does not involve a private initiative. One alternative for receiving funds immediately would require that the state "sell" part of its future tax proceeds. Whereas this alternative is financially possible, private investors will demand a guarantee against a legal change that substantially changes the way the graduate tax operates. Another possible alternative for obtaining immediate funding is to impose the graduate tax upon all existing graduates, a measure that changes the rules of the game for those who already attended school. Such an alternative, however, raises equity concerns and would face huge political opposition.

> Finally, the percentage of income that will represent the graduate tax will be the result of

> a political process, rather than something that reflects the value of education. To start, in

> order to accurately reflect the expected value of education, the tax would have to be different for individuals attending different schools and pursuing different careers. It would also have to discriminate somehow for other factors, particularly ability, to be a

> real measure of the value. Most probably the tax will be the same for all, regardless of the

> 18 Except if that particular country, **like** the United States, taxes its citizens for the income they earn abroad.

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Financing Lifelong Learning Miguel Palacios cost of attending school and the<sup>benefits from pursuinga particularcareer in a particular</sup> school. In doing so the graduate<sup>tax losesoneof the most desirable characteristicsof</sup> HCCs: the potential to convey information<sup>to the marketregarding the value of</sup> education. Therefore, the potential<sup>pressureon educationalinstitutions createdby</sup> information regarding the expected<sup>valueof educationfrom particularinstitutions and</sup> careers would not exist with<sup>the graduatetax.</sup>

# _Income-Contingent Loans_

The last income-contingent<sup>repayment schemethat isdiscussedhereis the income-</sup> contingent loan (ICL). An ICL<sup>collectsa percentageof incomefrom a graduate</sup><sup>_until the_</sup> _value of the loan has been repaid_<sup>_or until a maximum repayment period has been_</sup> _reached._ Income-contingent loans<sup>have been the most publicized"new instrument"for</sup> financing education and there<sup>has beena growing bibliography that supports them.Asa</sup> result of this, several countries<sup>have implemented income-contingent repaymentschemes.</sup> The main parameters of ICLs<sup>are theinterest rate, the repayment period,the percentage</sup> of income paid by the student, the<sup>collectionmechanism,andthe conditionsof</sup> termination of a student obligation.

The conditions of termination of<sup>a student'sobligationare of particular importancein</sup> ICLs because they determine<sup>whofills the gap left by a studentwho doesnot earnenough</sup> to repay the loan and interest.<sup>Traditionally two answers have beengiven:other students,</sup> and government. In the former<sup>case, students aregrouped in cohorts and are expected to</sup> repay until the cohort has completely<sup>repaidthe loan,evenif that entailssomestudents</sup> paying _more_ than 100% of the<sup>value of the loan.The excessthat some students pay is</sup> used to cover for the losses generated<sup>by low-income-earners. Whengovernmentcovers</sup> the loss from incomplete payments,<sup>studentsaresimply expected to repay100% of the</sup> loan. I show in "Human Capital<sup>Contractsand Human Capital Options"(See Palacios</sup> (2001)) that there is a third alternative<sup>for coveringthe unmet paymentsthat consistsin</sup> recognizing the low-income protection<sup>offered by income-contingentloans as a financial</sup> option. If this alternative is<sup>followed, each student would be required to pay a percentage</sup> above the total value of the<sup>loanto "pay"for theoption.The extra payment each student</sup> makes should then suffice to cover<sup>theexpensesnot paid by others.</sup> As discussed for Human Capital<sup>Contracts,income-contingentloans can be collectedby</sup> government to make use of existing<sup>institutions that estimateindividuals'incomesand</sup> collect taxes based on it. Barr<sup>(2001)hasargued in favorof systemsin which the tax-</sup> collection agency, or the national<sup>insurancecontribution system collectspayments.He</sup> argues that the marginal cost for<sup>the stateis relativelylow giventhe machinery it already</sup> has in place. Chapman's findings<sup>(1997)regardingthe collectioncostfor the Australian</sup> government support this position.<sup>Thisproposalcan beextendedto includeindependent</sup> authorities. Johnstone (2001b)<sup>has arguedagainst theapplicability of such an</sup> arrangement in other countries<sup>wherecollectingpayments throughthe taxmachinery</sup> might hamper the disposition of<sup>citizens to declareand pay their taxes, or where tax-</sup> collection agencies are not capable<sup>of collecting payments.</sup> 20
> Financing Lifelong Learning

> Miguel Palacios

Advantages: Income-contingent loans (ICLs), like HCCs and the graduate tax, decrease the risk for the student in terms of their earnings-net-of-education-payments. Also, like HCCs and the graduate tax, ICLs eliminate default risk due to financial distress. Thus, they retain the most important advantage of income-contingent repayment schemes.

ICLs also satisfy a concept of fairness based on dynamic equity, since students end up paying less than the value of the loan only if they end up with low incomes during the repayment period. Dynamic equity is not perfect, since once the value of the loan has been repaid, students who enjoy high incomes during the repayment period end up much better off than the rest. However, from a cost-recovery perspective, tuition cost is forgiven only for students with low lifelong incomes.

Another advantage ICLs have is the lack of a strong adverse selection problem. Students who see in themselves high future incomes will not have an unlimited liability and will not have a disincentive to join. However, there will be some adverse selection as long as students have to pay a "premium" for protection against low-income. Still, a reduction in adverse selection is very important for the proper functioning of ICLs.

Also related to the fact that payments are capped, ICLs do not create such a high incentive to hide income. Hiding income only pays off for those with such low incomes that they see the possibility of not repaying the loan entirely. 1<sup>9</sup> Thus, an ICL system might require less control on the amounts that students are reporting as their incomes, eventually reducing administration costs. For instance, as Johnstone (1972) proposed, a scheme where fixed payments are expected from all _except_ from those who prove low income would shift attention from focusing on income generated by all students to income generated by some students (those who cannot complete their payment). This is the way Chile's University credit ("Credito Universitario") works. Students pay the maximum of 5% of their income and a fixed amount (see Camhi and Latuf, 2000).

> To conclude, ICLs only create a disincentive to work for those who have low-incomes. High-income earners will repay their debt completely, and thus do not perceive a

> difference between different jobs with different wages. This contrasts with the effect of HCCs and the graduate tax, where the disincentive exists for any salary range.

# Weaknesses and Obstacles to Implementation:

ICLs share with HCCs and the graduate tax some common weaknesses and obstacles to implementation. They require the measurement of income, are subject to some adverse selection and distort the labor market, though to a _lesser_ degree. By far their greatest disadvantage, when contrasted with HCCs, is that they do not reflect purely expectations

> **19** This "disincentive" to hide income decreases if the interest rate on the loan is subsidized. In that case, the longer that an individual takes to repay the loan, the higher the value of the subsidy received.

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Financing Lifelong Learning Miguel Palacios on the value of education. Thus, they<sup>do not promote competition between institutionsin</sup> the way that HCCs do.

# _Conclusion Cost-RecoveryAlternatives_

Traditional "mortgage-type" loans can<sup>be a simple solution for financing education,but</sup> do not seem to be effective. On the positive<sup>side,they can be attractiveto private capital</sup> (at a considerable discount, of course).<sup>However, theydo not seem to be aneffective</sup> cost-recovery scheme and they would not<sup>be easily available to those students whoreally</sup> need it. Finally, they might not attractive<sup>for studentsbecausethey do not adjustto their</sup> capacity to pay.

Human Capital Contracts represent an<sup>alternativethat addresses themostimportant</sup> concerns regarding traditional "mortgage-type"<sup>loans.HCCs decreaserisk for the student,</sup> compensate investors for risk by offering<sup>upsidepotential, and offer informationto the</sup> market regarding information on the<sup>expected valueof education.As describedhere they</sup> are funded through private capital,<sup>and can be madeaccessibleto studentsbased on</sup> factors other than family wealth. In spite<sup>of thesepositivefeatures,HCCsrequirecertain</sup> conditions to be implemented, in particular<sup>a reliable way of determiningan individual's</sup> income. HCCs may also create a disincentive<sup>to work.Further,theirexistencedependson</sup> the capacity of investors to avoid adverse<sup>selection.</sup> The graduate tax, like HCCs, also addresses<sup>someof the problemsof traditionalloans.It</sup> can be universally applied and students<sup>will not have the burden of an inflexibledebt.</sup> However, there are other features that make<sup>them lessattractivethan HCCs.First,the</sup> percentage of income required as a tax<sup>islikely to be determinedby political process,</sup> rather than by the expectations of the<sup>value of education.This destroysthe possibility of</sup> using the graduate tax as an instrument that<sup>conveysinformationtothe market regarding</sup> the value of education. Second, it is<sup>not likely thatit can raise privatefunds. Finally,</sup> implementing graduate taxation also<sup>requiresthemeasurementof anindividual's income,</sup> and an effective tax-collection agency;<sup>otherwise,only particular segmentsof the</sup> population would end up paying it.

Finally, income-contingent loans decrease<sup>risk forthe student, have attractedprivate</sup> capital in the past, and do not have the<sup>negativeincentivespresent in HumanCapital</sup> Contracts and the graduate tax. Their<sup>only particular disadvantage, when contrasted</sup> against Human Capital Contracts, is that<sup>they do not offerinformation to themarket</sup> regarding the expected value of education.

# **_Subsidization Alternatives_**

Having completed an overview of the<sup>most relevant cost-recovery mechanisms,this</sup> section turns to subsidization alternatives.<sup>Theseare the alternativesfor financing</sup> education that are used to implement<sup>governmentsubsidizationof education.These</sup> schemes are concerned with the mechanisms<sup>available to policymakersto provide aid for</sup> education. The main methods considered<sup>hereare:(1)public funding of educational</sup> 22
Financing Lifelong Learning Miguel Palacios institutions and (2) vouchers and voucher-like instruments. As is the case with costrecovery schemes, the methods for subsidizing education are usually combined.

The following discussion focuses on how these instruments operate and the main arguments in favor of and against them. The following discussion does not answer the question _how can the state finance these subsidies?_ It is precisely because most governments do not have room for additional spending that cost-recovery schemes have been increasing in popularity. However, as discussed in the first section, government can improve equity in the education market using a combination of cost-recovery and subsidies, making the following discussion relevant for policymakers.

# _Public Funding of Educational Institutions_

Under this arrangement government owns and funds educational institutions. Transfers are negotiated directly between government and institutions to cover educational expenses. Although usually the educational institutions themselves are public institutions, this is not always the case. For the foreseeable future, educational institutions are likely to continue receiving direct funds from the state in the same way that they have received funds in the past. However, it is expected that the proportion of funds received as a share of total income will decrease as governments seek other altematives for funding education.

Since public funding of higher educational institutions is in widespread use today, it is usually not considered an option for solving the problem of funding education. Rather, it is seen as the status quo that can be improved. The main problems usually associated with the direct public funding of higher-education institutions are (1) the lack of responsiveness of institutions to the needs of students and labor markets and (2) the inequity of public financing of a good that benefits mostly its user. Presumably, the same results can be expected when learning providers are state-funded.

The lack of responsiveness of institutions to the needs of students and labor markets are the result of the existing incentives. The primary constituency of school administrators is not the student body, or the labor market, but the agencies in government responsible for giving schools the funds to operate. Naturally, school administrators try to satisfy public agencies' needs, rather than those of students. The second problem, the inequity of financing public schools arises from the fact that public funds are used to fund individuals who then appropriate the benefits through higher earnings. Thus, funding higher-education institutions translates into a transfer from the taxpayer to relatively high-income earners.

For lifelong learning in particular, there are two additional arguments against public provision of education. First, because there is a wide and complex variety of fields for training, the effort that centralized public agencies would have to make to align services offered with market demand is far more complicated than in higher-education. Second, embracing lifelong learning requires accepting informal education mechanisms, such as 23
Financing Lifelong Learning Miguel Palacios on-the-job training, which are hard<sup>to model in the context of a public education</sup> institution.

As a consequence, even though public<sup>fundingof higherand othernoncompulsory</sup> education will continue for a time, a<sup>complete solution for financinglifelonglearning</sup> does not lie in public funding. The<sup>attention has gradually shifted towardsthe alternatives</sup> explored below, where government<sup>givesfunds directlyto students.20</sup>

# _Vouchers_

Vouchers have been discussed as<sup>analternative togovernment runningeducational</sup> institutions. The basic idea behind<sup>a voucheristo give the resourcesto students so that</sup> they can go and enroll in the educational<sup>institutionof their choice.This is the essence of</sup> demand-side financing.

The main policy considerations<sup>whendesigningvoucher programsare:2'</sup>

- **Voucher amount:** How much will<sup>be given toeach student?Willit</sup> depend on the school the individual<sup>attendsor on the field of study</sup> pursued? Will it be proportional<sup>to tax payments? To trainingcost?To</sup> students who save? To income? Other<sup>variables?</sup>

- **Student spending limit:** Is the voucher<sup>supposed to cover the wholecost</sup> of education, or can the student add<sup>tothe voucher value to pay for</sup> tuition? Can the voucher be used<sup>for other costs, suchas transportation?</sup>

- - **Voucher target:** Will the voucher<sup>be givento everybody?Onlystudents</sup> from particular income backgrounds?<sup>To particular schools?</sup>

- **Voucher use:** For what kind of education<sup>are vouchers going to be used?</sup> Basic education? General skills training?

The answers to the previous questions<sup>are very extensiveand thereare severalexamples</sup> of voucher-like instruments that<sup>have beenimplemented or proposedin thepast.Some</sup> examples relevant for lifelong learning<sup>are entitlements,LearningandSavingsAccounts,</sup> and tax credits.

Entitlements are, as proposed by<sup>Levin (1983),a combinationof vouchersand loans to</sup> finance a wide variety of types of<sup>learning.22LearningandSavingsAccountstry to</sup> encourage savings while at the same<sup>time providing vouchers to individuals interestedin</sup> pursuing additional education. Tax<sup>creditsalsoencourageinvestmentsin education by</sup>

> 20 Because public funding of higher-education<sup>institutions is likely to continuein theforeseeablefuture,</sup> some authors have offered alternatives<sup>to make theirworking more efficient.For instance,see Ziderman</sup>

> (1995) for a discussion on how public<sup>allocationof funds can be improved.</sup>

> **21** For an exposition of different types<sup>of vouchers see Blaug (1984).</sup>

> 22 Levin's system is cited in the<sup>literatureas the mostcomprehensivefor financinglifelonglearning.See</sup> Oosterbeek (1998).

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Financing Lifelong Learning Miguel Palacios reducing the amount of taxes that an individual has to pay if he or she invests in education. 23

# Advantages:

There are two main reasons why economists and others advocate vouchers: vouchers (1) are a subsidy that increase consumer sovereignty, thereby increasing efficiency in the education market, and (2) vouchers can be used to target particular social groups, thus fostering equity in society.

Vouchers give their holder the option to attend any educational institution as long as it is "approved" by authorities. By choosing, individuals reveal their preferences regarding what they want to study, and what particular provider they like. By choosing some institutions over others, and some courses over others, individuals spur competition among educational institutions and give them an incentive to offer the courses that individuals demand. The result is a more efficient educational market.

In addition to the increased efficiency in the educational market, governments can use vouchers to target certain social groups. In particular, targeting vouchers to social groups that are systematically misinformed regarding the value of education can help compensate for the particular circumstances that lead them to systematically under-invest in human capital.

# Weaknesses and Obstacles to Implementation:

As with any source of public aid, the administration of a voucher program requires controls in order to prevent their misuse. In turn, these controls increase the cost of the program and make the system more complex from the point of view of the user. The recent Individual Learning Accounts program in the United Kingdom testifies to the results of a poorly controlled voucher system.

An obstacle to implementation is the way public opinion and legal institutions view the transfer of funds to private entities. In the United States in particular, a major obstacle to the introduction of voucher-like systems is the perception that public funds are being used to sponsor religious activities. In spite of this being principally a problem for basic education, it is conceivable that the issue could be raised when vouchers are used to train in vocational institutions run by particular groups, such as religious organizations. This, however, is not an important issue in developing countries.

# Conclusion:

Vouchers enhance efficiency in the education market and can be used to promote equitable access to education, making them a preferable alternative to the direct transfer of public funds to educational institutions. However, their design can be quite complex 23 See Olsen, Darcy and Brouillette, Mathew. "Another Path to School Choice" _Washington Times,_ December 13, 2000.

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Financing Lifelong Learning Miguel Palacios and entails an important political effort,<sup>and their execution requirescontrolsystemsto</sup> ensure that public funds are being used in<sup>theway they were intended to be used.</sup>

## **_Combining Alternatives to Succeed_**

No single alternative among the ones<sup>discussedabove addressesall the problemsof</sup> financing education, and lifelong learning<sup>in particular.In general,cost-recoveryschemes</sup> try to find additional immediate capital<sup>to financeeducationfor everyonebut do not</sup> address the problem of equitable access.<sup>On theother hand,voucher-like instrumentsare</sup> targeted towards disadvantaged groups<sup>but do not solvethe problem of funding.It is</sup> quite clear that the best arrangement<sup>is a combinationof cost-recoveryschemesand</sup> voucher-like instruments.

In fact all financing schemes devised<sup>so farare a combination of the two.From the</sup> simple subsidized "mortgage-type" loan,<sup>where theloanis the cost-recoveryscheme,and</sup> the subsidy a particular kind of voucher<sup>24,to complexsystemslike the Chilean one,all</sup> alternatives combine cost-recovery<sup>with subsidy.Even Levin'soriginalentitlement</sup> proposal (1983) was a combination of<sup>grants andloans.But, istherean optimal</sup> combination?

From the discussion of cost-recovery schemes,<sup>it seems that a combinationof income-</sup> contingent loans _and_ a small dose of<sup>HumanCapital Contractscan offer the best of all</sup> worlds.<sup>2 5</sup> By combining ICLs and HCCs<sup>with a voucher-likesystem,all the basic</sup> conditions defined in the first section are<sup>met:individualsare responsible for their</sup> training, carry an important part of the<sup>financialburdenbut do not haveto pay for it up-</sup> front; government provides resources<sup>througha system that promotesefficiencyin the</sup> education market; the instrument has<sup>adverseeffects on the labor market only for low-</sup> income earners; finally, if the voucher-like<sup>system isavailablethroughoutan individual's</sup> life, it promotes spreading learning over<sup>a lifetime.</sup>

# **111. Conclusions**

We now conclude with a short guide on<sup>keyelements that governmentsandmultilateral</sup> institutions like the World Bank should<sup>consider when embarkingon thedesign and</sup> implementation of lifelong learning<sup>policies.</sup>

## **_The Preferred Model_**

The conclusion from the first part of<sup>thispaper is that the modelthat best addresses the</sup> financing of lifelong learning is a voucher<sup>programin combination with income-</sup> contingent loans and Human Capital Contracts.<sup>Such a combination addresses equity</sup>

> 24 This particular voucher is proportional<sup>to theamount of the loan and is offered to whoever takes the</sup> subsidized loan.

> 25 In fact, such a system could be devised<sup>throughtheintroductionof HumanCapital Options.</sup> Combinations of options and equity arrangements<sup>createincome-contingentloans. See Palacios(2001).</sup>

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Financing Lifelong Learning Miguel Palacios concerns, both from a static and dynamic point of view, and promotes efficiency in the labor and education markets. In line with the objectives of lifelong learning, entitlements should be available for a wide variety of skills, should promote saving, and should promote spreading learning throughout the productive life of the individual.

# _The Role for Governments_

The way that governments face the problem of financing lifelong learning will result in consequences that affect an important part of the population. Following is an important set of challenges that governments will face in order to create a suitable system for financing lifelong learning:

- **Shifting towards cost-recovery policies:** A sustainable, efficient and equitable system for financing lifelong learning requires a cost-recovery mechanism. Implementing such a mechanism can be a challenge given the tradition of free state-funded education.

- **Focusing on collection of payments:** The success of cost-recovery policies will depend on the success in collecting payments from former students. The participation of tax-collection agencies or social security systems is a possibility that should be considered.

- **Involving private capital:** A substantial increase in the amount of resources available for financing education, particularly for lifelong learning, is not feasible without the intervention of the private sector. Attracting private capital will probably require commitment to honor agreements, guarantees from governments, aid in collecting payments, and decisions by private parties on the particular characteristics of each instrument offered. This can be done with the help of multilateral organizations, such as IFC has done with loan programs.

- **Designing voucher-like systems:** A complete scheme for financing lifelong learning requires subsidies from government. Following the above discussion, these should ideally be voucher-like systems. Government needs to make a political decision to support these systems. Particularly for financing lifelong learning, a decision has to be made to make vouchers available to the population for different types of training and for the period in life that the individual chooses to attain more knowledge. Vouchers can be made available at any given moment, or after the individual has saved for learning. Finally, vouchers should also be targeted to particular marginalized socioeconomic groups.

- **Providing Information:** An important feature that contributes to making the education market more efficient is the compiling and distribution of information regarding the quality of educational institutions, costs of education and the demand for particular skills.

Notice that once the decision to proceed with cost-recovery schemes is made, the subsequent steps that government needs to take in order to ensure the success of a costrecovery scheme are aligned with its interests in other areas. For example, the 27
Financing Lifelong Learning Miguel Palacios development of an effective tax-collection agency is key to the capacity<sup>of thestate to</sup> create change. The measures needed to attract private capital for funding<sup>lifelonglearning</sup> are the same as those required to attract-private capital to invest in the country<sup>in the long</sup> run: stable laws, facilitated by a de,veloped financial system.

# _The Role of the World Bank_

As the requirements for financing lifelong learning increase, the need<sup>for fundingwill</sup> increase. How should multilateral institutions like the World Bank react<sup>to this?It is</sup> important to distinguish between two needs that governments will have:<sup>(1) help on how</sup> to finance the cost-recovery schemes and (2) help on how to finance the voucher programs.

The role of the World Bank on how to finance cost-recovery schemes should<sup>be limited,</sup> since the ideal situation is that in which private capital is involved. On the<sup>other hand, the</sup> World Bank can have an important role to play on financing voucher<sup>schemes, since</sup> these entail public expenditures (and presumably, public benefits from<sup>the investment).</sup> But since most schemes will be a combination-6f cost-recovery instruments and vouchers, the bank will probably be involved in the overall design of the<sup>project. Hereare</sup> some points that should be taken into account.

- **Advice:** The World Bank has theoretical and empirical knowledge<sup>of what</sup> is successful and what is not. This knowledge should be used to provide advice to countries facing the challenge of financing lifelong learning.

- - **Institutional Reform:** Institutions are a factor in the success or<sup>failureof</sup> several of different financial schemes. The bank can aid in the creation<sup>of</sup> institutional arrangements that aid in the financing of lifelong learning. For example, the World Bank can promote income-contingent repayment schemes by placing emphasis on the ability of the state to collect payments through a tax-collection agency.

- **Attracting of Private Capital:** IFC has identified the role that the<sup>private</sup> sector can play in financing education as helping alleviate financial constraints, improving equity and enhancing social mobility (see IFC, 2001). Because the involvement of private capital is a key issue in the funding of lifelong learning, the bank can promote arrangements<sup>that</sup> make the use of private capital possible. Some possible alternatives include risk-sharing arrangements, guarantees from the bank, and<sup>the</sup> promotion of secondary markets where education-financing instruments can be traded globally.

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