metadata: authors: 0: author: Lachler,Ulrich
count: Mexico
docna: 0: docna: Education and earnings inequality in Mexico
docty: Policy Research Working Paper
subtopic: Public Sector Economics,Primary Education,Tertiary Education,Educational Sciences,International Trade and Trade Rules,Public Financial Management,Public Finance Decentralization and
            Poverty Reduction
teratopic: Gender
abstracts: cdata!: Education attainment levels increased
            dramatically for Mexico's labor force in the 1980s and
            early 1990s.  In parallel, the country experienced a
            pronounced increase in earnings inequality from 1984-94,
            reflected in a higher dispersion of wages and an absolute
            decline in the real incomes of less educated, poorer
            Mexicans.  This increased wage dispersion presents
            policymakers with a tradeoff between efficiency
            considerations (favoring increased spending on higher
            education) and equity considerations (favoring a more equal
            distribution of per student spending) in the allocation of
            fiscal resources to education.  The author concludes that
            the best way to deal with this equity-efficiency tradeoff is
            to encourage greater private participation in higher
            education.  His main findings are that: a) The accumulation
            of human capital during 1984-94, as proxied by education
            attainment, was accompanied by a more equal distribution of
            education attainment levels over that period and, thus,
            exerted an equalizing effect on the distribution of incomes.
            The increased income inequality observed over that period
            appears to be caused by an increased rate of skill-based
            technological change, whose transmission to Mexico and other
            developing countries may have been facilitated by the
            increased openness of their economies.   b) The greater
            dispersion of wager observed in Mexico during the past
            decade raised the rates of return on investing in higher
            education, reversing the traditional pattern where primary
            education exhibits the highest rates of return.  c) The
            social rates of return across levels of schooling were more
            uniform in 1994 than in 1984, suggesting a more efficient
            assignment of education spending.  At the same time, the
            distribution of spending on education became more
            egalitarian, as per student spending in higher education
            declined markedly compared with per student spending at the
            primary level.  This surprising coincidence in the pattern
            of spending on education was only possible because Mexico
            started out with a very distorted resource allocation in
            education that was both highly inequitable and inefficient.
            As Mexico's policymakers are on the way to correcting
            these distortions, the opportunities for avoiding the
            equity-efficiency tradeoff within Mexico's centralized
            education framework will become progressively exhausted.  d)
            There is little reason to expect the pace of technological
            change, which appears mainly responsible for raising wage
            dispersion and the relative returns on higher education, to
            abate.  Efficiency considerations dictate that Mexico should
            respond by devoting more resources to higher education.
            However, the federal budget, which traditionally has
            financed the lion's share of higher education costs in
            Mexico, is unable to accommodate additional spending on
            higher education, while spending cuts elsewhere in the
            education sector are bound to raise serious equity
            questions.  Thus, to avoid falling behind in terms of human
            capital accumulation, greater private sector participation
            is necessary, at least, in terms of cost recovery from the
            main beneficiaries of higher education.
geo_reg_key: 119228,517191
repnme: repnme: Education and earnings inequality in Mexico
display_title: Education and earnings inequality in Mexico
listing_relative_url: /research/1998/07/693464/education-earnings-inequality-mexico
topicv3: Primary Education m1326139 480,Public Finance Management m1326316 716,Tertiary Education m1326349 482,Trade m1326924 698,Education m1327048 470
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Gender
origu: WB Off: Mexico - MX CMU (LCC1C)
no_of_pages: 32
author_keys: 0: author_key: 93153
model_extractions: | POLICY RESEARCH WORKING PAPER 1949

# Summary findings

Education attainment levels increased dramatically for Mexico's labor force in the 1980s and early 1990s. In parallel, the country experienced a pronounced increase in earnings inequality from 1984-94, reflected in a higher dispersion of wages and an absolute decline in the real incomes of less educated, poorer Mexicans. This increased wage dispersion presents policymakers with a tradeoff between efficiency considerations (favoring increased spending on higher education) and equity considerations (favoring a more equal distribution of per student spending) in the allocation of fiscal resources to education.

Lachler concludes that the best way to deal with this equity-efficiency tradeoff is to encourage greater private participation in higher education. His main findings are that:

* The accumulation of human capital during 198494, as proxied by education attainment, was accompanied by a more equal distribution of education attainment levels over that period and, thus, exerted an equalizing effect on the distribution of incomes. The increased income inequality observed over that period appears to be caused by an increased rate of skill-based technological change, whose transmission to Mexico and other developing countries may have been facilitated by the increased openness of their economies.

The greater dispersion of wages observed in Mexico during the past decade raised the rates of return on investing in higher education, reversing the traditional pattern where primary education exhibits the highest rates of return.

* The social rates of return across levels ol schooling were more uniform in 1994 than in 1984, suggesting a more efficient assignment of education spending. At the same time, the distribution of spending on education became more egalitarian, as per student spending in higher education declined markedly compared with per student spending at the primary level. This surprising coincidence in the pattern of spending on education was only possible because Mexico started out with a very distorted resource allocation in education that was both highly inequitable and inefficient. As Mexico's policymakers are on the way to correcting these distortions, the opportunities for avoiding the equityefficiency tradeoff within Mexico's centralized education framework will become progressively exhausted.

* There is little reason to expect the pace of technological change, which appears mainly responsible for raising wage dispersion and the relative returns on higher education, to abate. Efficiency considerations dictate that Mexico should respond by devoting more resources to higher education. However, the federal budget, which traditionally has financed the lion's share of higher education costs in Mexico, is unable to accommodate additional spending on higher education, while spending cuts elsewhere in the education sector are bound to raise serious equity questions. Thus, to avoid falling behind in terms of human capital accumulation, greater private sector participation is necessary, at least in terms of cost recovery from the main beneficiaries of higher education.

- - This paper a product of the Mexico Country Department emerged from research in the preparation of the 1998 Country Economic Memorandum and is part of the department's larger effort to engage in a fruitful economic policy dialogue with Mexican policymakers. Copies of the paper are available free from the World Bank, 1818 H Street NAWT, Washington, DC 20433. Please contact Carmen Lazcano, room 14-135, telephone 202-473-7776, fax 202-522-2113, Internet address clazcano@worldbank.org. The author may be contacted at ulachler(worldbank.org. July 1998. (27 pages)

_The Policy Research W'orking Paper Series diysemiates the findings of work_ **_isn_** _progress to encourage the exchaege of ideas about I development issues. An objective of the series is to get the findings out q,uickly, even if the presqentationis are less thanl fulfly polisbed. Th2e papers carry the names of the authors_ **_aiid shouild_** _be cited accordiiigly. The fipidinzgs, interpretations, and coniclusionis expressed ;1V this paper are entirely those of the authors. They do not necessarily represent the vieuw of the WGorld Bankz, its Executive Directors,_ **_or-_** _the countries they represent._ Produced by the Policy Researclh Dissemination Ceniter
# EDUCATION **AND** EARNINGS INEQUALITY IN MEXICO

## Ulrich Lachler*

* Principal Economist, Mexico Country Department, World Bank.

This paper was prepared with research assistance from Gladys Lopez Acevedo, who processed the ENIGH data discussed therein. Many helpful comments were received from Barry Bosworth, Nancy Gillespie, George Psacharopoulos, RosaMaria Rubalcava, Fernando Cortes, Enrique Hernandez Laos, and Eduardo Velez.
# EDUCATION AND EARNINGS INEQUALITY IN MEXICO

The education attainment of Mexico's labor force increased dramatically during the 1980s and early 1990s, contrasting markedly with the uneven accumulation of physical capital. At the same time, the rates of return on investments in different levels of schooling show significantly less dispersion than they did a decade ago. This suggests that investment in education has been taking place in a more socially efficient manner. Another visible development over the last decade, however, has been a significant increase in earnings inequality, accompanied by an absolute decline in the real incomes of the less educated, poorer members of society. This comes as something of a surprise in light of the great equalizing properties generally attributed to education, but is a phenomenon that in recent years also has been observed in other developing as well as developed countries.

The increased wage dispersion presents policymakers with two challenges: the more immediate one is how to respond to the decline in real incomes facing a large share of the country's population. The other related challenge, with implications for the country's long-term growth prospects, concerns a tradeoff in the allocation of resources in education and is especially acute in relatively centralized education system such as Mexico's. Since the increased wage dispersion raises the rate of return from investing in higher education, economic efficiency considerations would dictate a response that devotes relatively more resources to higher education versus other levels. A resource reallocation to that effect, however, means transferring resources toward segments of the population that are already better off, thus conflicting with equity considerations.

Mexico's policymakers were able to avoid this policy dilemma over the last decade: as shown below, the allocation of public spending on education has become somewhat more egalitarian and, at the same time, the social rates of return associated with different levels of education have become more uniform. This happy coincidence was possible only because Mexico started out with a very distorted resource allocation in education. As past resource misallocations are corrected, however, the opportunities for further improvements in resource allocation within the existing, centralized education framework are progressively exhausted. This is likely to result in increasing tensions in the allocation of fiscal resources -- between efficiency considerations that argue for more resources to higher education and egalitarian considerations that argue for a more equal distribution of transfers within and outside the education sector. This paper argues that the most promising way of dealing with these tensions is by seeking to clarify the roles for the public and private sectors in education and by encouraging greater private participation in higher education.
2

# **A. The Growth of Education Attainment**<sup>**1**</sup>

Education attainment levels increased rapidly in most developing countries since the 1950s; Schultz (1988). While Mexico also partook in that development, earlier studies had identified a significant lag in its education indicators. Londonto (1996), for example, points to an "education deficit", according to which the Latin American countries in general, and Mexico in particular, have approximately two years less of education than would be expected for their level of development (as measured by per-capita incomes). Elias (1992) finds that education was the most important source of labor quality improvement in Latin America between 1950 and 1970, but points out that such improvements did not take place to the same extent in Mexico. This changed dramatically in the 1980s, as shown in the scatter diagram below.

Figure 1 describes the relation between income per capita and average years of schooling of the population aged 15 years or more, using stacked cross-country data for the years 1960, 1970, 1980, 1985 and 1990.2 Mexico's level of education

- 'The following discussion primarily focuses on the evolution of education attainment levels as measured by years of schooling, on the assumption that the quality of education has remained more or less constant. Although it is of great interest in this context, information on the quality of education in Mexico is very scarce. The most common measures of "quality" are based on input measures, (e.g., real expenditures on education per student, student-teacher ratios, or class-density variables) or secondary performance variables (e.g., evolution of repetition and desertion rates). On the basis of these measures, Mexico also has performed comparatively well over the last few decades. These measures are not very satisfactory, however, as they reflect many other influences in addition to the quality of instruction as reflected in the acquisition of knowledge and skills. A comprehensive education survey was conducted in Mexico in 1995 as part of the Third International Mathematics and Science Study (TIMMS) that may have yielded important data to permit correlating the preceding education sector characteristics with academic achievement levels to obtain a better understanding of the determinants of education quality in Mexico. That data set has not been made publicly available.

- 2 The scatter diagram in Figure 1 is based on 317 observations from five different years. The observations pertaining to Mexico, ordered by date, are as follows:

Ave. Schooling (years) Ln (GDP per capita; 1980 US$) 1960 2.76 7.95 1970 3.68 8.29 1980 4.77 8.71 1985 5.20 8.63 1990 6.72 8.67 The trend line represents the least square regression line given by: S = -13.17 + 2.28 Ln(GDPcap) Adj. R<sup>2</sup> _=_ 0.68 (-18.7) (26.0) t-values in parentheses

- The application of Ramsey's RESET test to this regression equation failed to detect a specification error; unlike with the alternative specification of type: S = a + bX + cX<sup>2</sup> . However, coefficient stability tests indicated that the trend line is not constant across decades. This is reflected in the upward drift of the coefficients associated with the dummies in the following equation:

- S = -13.20 + 2.21 Ln(GDPcap) + 0.023DUM70 + 0.525DUM80 + 0.833DUM 85 + 0.997DUM90 (-19.0) (25.4) (0.1) (1.7) (3.0) (3.6) Adj. R<sup>2</sup> = 0.70, t-values in parentheses
<!-- Start of picture text --> Figure 1<br>Cross-Country Relation between Education Attainment and GDP<br>12 -<br>10 :*.+# .<br>Mexico 1990<br>8<br>6<br>4<br>o<br>0<br>5.00 S.S0 6.00 6.50 7.00 7.50 8.00 8.50 9.00 9.50 10.00<br>Ln (GDP per capita)<br><!-- End of picture text --> Source: Penn **World Tables,** mark **5.6,** and Barro-Lee data set on international measures **of** schooling. **The** chart **is based** on stacked cross-country data for 1960, 1970, 1980, 1985 and 1990. Country coverage varies according to data availability. U.1-achler
4 attainment in 1960 was significantly below the world mean for countries at similar levels of economic development. Although Mexico's education attainment increased steadily over the following two decades, it continued to remain below the international trend line. In the 1980s, however, the growth of education attainment in Mexico accelerated, permitting it to catch up to international standards by 1990; where its placement in Figure 1 is slightly above the trend line.

The closure of Mexico's education gap vis-a-vis the rest of the world was hastened in part by the country's economic stagnation. Mexico's real GDP per capita in the mid-1990s was roughly the same as it had been in the first half of the 1980s. Had Mexico continued to grow at the same pace as in the 1960s and 1970s (and assuming that the gains in education attainment remain the same), its 1990 placement in Figure I would have continued to remain below the cross-country trend line, though at a much reduced distance compared to previous years.<sup>3</sup> The preceding observation, however, should not detract from the remarkable increase in schooling that occurred during the 1980s. While average schooling level in Mexico increased by roughly one year per decade during 1960-1980 (from 2.76 to 4.77 years), it increased by two years in the decade between 1980-1990. As described in Psacharopoulos et al (1996), this rapid improvement reflects the great efforts made in Mexico to increase both the quality of and access to public education since 1950. A consequence of these developments is that the share of workers with less than primary education decreased from almost half of the labor force in 1984 to 36 percent in 1994, while the share of workers with at least a completed secondary education increased from 26 to 39 percent; Table 1.

The rapid growth of education attainment in Mexico also stands out in recent cross-country growth studies (e.g., Bosworth, 1997), which decompose per capita growth into the contributions from several factors, including education attainment as a proxy for human capital accumulation, in a growth accounting framework. These studies reveal a major break in Mexico's growth performance after 1982. A similar break is visible in the accumulation of physical capital and in total factor productivity growth, but not in the accumulation of schooling, which performed well by world standards.

> 3 Mexico's education deficit -- i.e., the vertical difference from the world trend line in Figure 1 -- has declined significantly since 1960, with the main catch-up occurring in 1980-90. This is clearly visible from Figure 1, but also appears under less restrictive specifications of the estimated trend line. The differences from the trendline are stated below, beginning with the most restrictive specification:

|Equation Specification|1960|1970 1980|1985|1990<br>Std. Error of|
|---|---|---|---|---|
||(differe|nce from world|mean in|years)<br>Regression|
|Stacked, without dummies|<br>-2.22|<br>-2.09 -1.95|<br>-1.36|<br><br>+0.08<br>1.52|
|Stacked with dummy variables|-1.62|-1.49 -1.82|-1.54|-0.26<br>1.48|
|Individual equations for each year|_-1.55_|-1.41 -1.84|-1.59|-0.26<br>na|
_5_

# **B. Changes in Earnings Inequality**

At the same time as this remarkable advance in education attainment was taking place, the distribution of income in Mexico worsened notably; see e.g., De la Torre (1997), Panuco-Laguette and Szekely (1996). For example, the Gini coefficient of Mexico's total income distribution increased from 0.43 in 1984 to 0.48 in 1994. This deterioration took place before the 1995 recession and, thus, cannot be attributed to business cycle effects. Instead, the increase in overall income inequality appears to be closely related to an increase in the dispersion of wages and salaries across different schooling levels. Table 1 describes the change in real wages between 1984 and 1994, using two concepts of remuneration (described in Section D.)

**Table 1: Real Wage Rates in** Mexico (Unles **s** tated otherwise, all figures refer to hourly rates expressed in constant 1994 Pesos)

||Wa|ges**& S**|**alaries**|**Mo**|**netary**|**Income**|_Share o_|_f Workers_|
|---|---|---|---|---|---|---|---|---|
|_Schooling Level_|1984|1994|difference|1984|1994|difference|<br>1984|1994|
|0 -less than primary|3.17|3.08|-2.8%|4.83|4.12|-14.7%|48.1%|35.7%|
|1 - primary complete|5.23|4.42|_-15.5%_|7.90|5.39|-31.8%|26.3%|25.4%|
|2 - secondary complete|6.55|5.83|-11.0%|7.55|6.90|-8.6%|13.3%|21.3%|
|3-preparatory complete|9.62|11.68|21.4%|10.64|12.84|<br>20.7%|7.8%|11.1%|
|4-university and above|14.93|21.96|47.1%|16.94|25.55|50.8%|4.5%|6.6%|
|_weighted average_|**5.62**|**6.88**|22.4%|7.00|7.57|8.1%|||

Source: Own calculations based on ENIGH84 and ENIGH94. All figures are weighted averages using expansion factors to reflect national representation.

Even though the average wage increased during the decade spanned by Table 1, most workers experienced a significant decline in their wages. This disparity in the evolution of real wages is most visible in Figure 2, which shows that 83 percent of the working population experienced a decline in real wages during the last decade.

<!-- Start of picture text --> Figure 2<br>MEXICO<br>Percentage Change in Real Wages by Percentile: 1984-1994<br>40.00%<br>30.00%0<br>20.00% ~~based on .6<br>a , 10.00%<br>0.00%<br>e -10.00% 10 15 20 25 30 3 40 45 50 55 606570 85 90 95<br>CL -20.00%<br>.-30.00% ~-ory monetary incomes<br>-40.00%<br>Percentiles<br><!-- End of picture text --> Source: ENIGH84 and ENIGH94.
6 The deterioration of real wages was partly compensated for through increases in hours worked, suggesting backward bending labor supply curves at low income levels. This was not enough, however, to prevent an erosion of overall income for the majority of workers; Table 2.

Table 2: Average Hours Worked and Income Received

|_Schooling Level_|Wage Ea|rners|Mo|netary<br>Recipi|Income<br>ents|
|---|---|---|---|---|---|
|Avg.**Hours per Week**|1984 1994|change|1984|1994|change|
|0 - less than primary|44.8 50.7|13.3%|43.0|46.8|8.8%|
|1 - primary complete|45.1 49.0|8.6%|44.7|48.2|7.9%|
|2 - secondary complete|44.4 46.8|5.6%|44.5|46.8|5.2%|
|3 - preparatory complete|38.7 43.7|12.8%|38.9|44.1|13.4%|
|4 - university andabove|41.6 44.7|7.5%|42.2|44.7|5.9%|
|_weighted average_|_44.1 47.8_|_8.5%_|_43.3_|_46.7_|_7.8%_|
|Avg. Annual Income|1984 1994|change|1984|1994|change|
|(in 1994 Pesos)||||||
|0 - less than primary|7,530 7,674|<br>1.9%|_9,514_|8,308|<br>-12.7%|
|1 - primary complete|12,705 11,316|-10.9%|15,888|13,222|-16.8%|
|2 - secondary complete|15,343 14,097|<br>-8.1%|16,995|15,978|<br>-6.0%|
|3- preparatory complete|18,643 25,709|<br>37.9%|19,483|27,898|<br>43.2%|
|4- university and above|33,899 55,428|<br>63.5%|38,741|62,769|<br>62.0%|
|_weighted average_|_13,057 16,65_|_8 27.6%_|_14,26_|_8 16,93_|_1_<br>_18.7%_|

Source: Own calculations based on ENIGH84 and ENIGH94. All figures are weighted averages using expansion factors to achieve representation at the national level.

One explanation for a deteriorating income distribution that is closely connected to the advance in education attainment has been made by Ram (1 990). Education is generally considered to have an equalizing effect on incomes, which would indicate a positive relation between measures of income inequality and of education inequality. However, the dispersion of schooling attainment and the mean level of schooling need not be positively related in a monotonic manner. Upon exploring this relationship by way of a cross-country analysis, Ram finds a curvilinear (Kuznets-type inverted-U) relation between the mean level of schooling and schooling inequality in the labor force.<sup>4</sup> That is, as schooling expands, education inequality first increases, but then starts declining after reaching a peak. That turning point occurs when mean schooling is

> 4The theoretical rationale underlying this fmding is reminiscent of the "Laffer curve" in public finance theory. It stated that tax revenues are 0 when tax rates are 0 and will again become 0 when the tax rate approaches 100% (as that would eliminate all incentive to work.) Since revenues are positive at tax rates between 0% and 100%, the revenue-rate relationship must broadly approximate an inverted-U. In the case of education, the "theory" states that when no one in society is educated, the distribution of education is perfectly equal, as it would be when everyone in society has a Ph.D. (considered for simplicity to be the maximal level of education attainment). In the process of going from a Zeroeducation society to the Land of Ph.D.s, the distribution of education must perforce become more unequal before it ultimately improves again.
7 about 6.8 years for the full sample of countries, and 6.3 years for the sub-sample of less developed countries. So, if Mexican schooling levels had been below the turning point, it is conceivable that the rapid increase of education attainment in the 1980s may have contributed to greater earnings inequality via an increased inequality of schooling attainment.

The evidence does not support this explanation for the increased earnings inequality in Mexico: using Ram's (1990) method of calculation based on 5 schooling levels, the mean level of schooling in Mexico was 6.45 years in 1984 and 7.65 years in 1994. This means that Mexico started in 1984 with a mean level of schooling that was slightly above the "turning point" according to the LDC subsample and slightly below the turning point for the full sample of countries, while it ended up in 1994 with a mean schooling level substantially above the turning point. If the curvilinear relation is evenly distributed around the turning point, we should clearly expect the inequality of schooling in Mexico to have declined over that decade.

This conclusion is confirmed by decomposing the change of the Gini Index between 1984 and 1994 into the proportion that is attributable to changes in the wage rate, in hours worked and in education attainment. Table 3 presents the results of such an exercise, both for the distribution of Wage and Salary incomes, as well as the broader Monetary income concept. For each income concept, several "synthetic" Gini indexes are calculated:<sup>5</sup> the first two, Gini-1984 and Gini-1994, are based on the distribution of wage rates, hours worked and education attainment that pertain in each year. The next three indexes are derived by recalculating the 1984 Gini index after successively replacing the 1984 distribution of wage rates, hours worked and schooling attainment by its 1994 counterpart. The second column under each income concept reports the value of each Gini index calculated in this manner, while the third column reports the percentage difference of these values relative to the original 1984 Gini index.

Table 3: Sources of Increased Earnings Inequality

|**Wage**|**s & Salaries**<br>|**Monet**|**ary Inc**<br>|**ome**<br>|
|---|---|---|---|---|
||Level %change over<br>Gini-84||Level|%change over<br>Gini-84|
|Gini 1984|0.2281<br>0.0|Gini 1984|0.1712|<br>0.0|
|Gini 1994|0.3034<br>33.0|Gini 1994|0.2812|<br>64.3|
|Gini-Awage|0.2962<br>29.9|Gini-Awage|0.2543|<br>48.5|
|Gini-Ahours|0.2208<br>-3.2|Gini-Ahours|0.1696|<br>-0.9|
|Gini-Aeducation|0.2222<br>-2.6|Gini-Aeducatio|n 0.1710|<br>-0.1|

Source: Own calculations based on data from Tables I and 2.

Note: the %-changes in the lower half of each column do not add up to the %-difference between Gini-94 and Gini-84 due to large rounding errors.

Table 3 indicates that the "synthetic" Gini index increased by 33 percent between 1984 and 1994 (under the Wage and Salary income concept) and that over 90

> 5 These "synthetic" Gini indexes are constructed under the assumption that all the individuals with a given schooling level earn the same wage rate and work the same number of hours as the averages shown for each schooling level in Table 2.
8 percent (29.9 . 33.0) of that increase in earnings inequality is attributable to the change in the distribution of wage rates over that decade. (Using the broader Monetary income concept, around 75 percent of the increase in earnings inequality is explained by the change in wage rates.) On the other hand, changes in the distribution of education attainment are shown in both cases to have contributed to a reduction in earnings inequality, though by modest amounts; -2.6 and -0.1 percent. Changes in hours worked also contributed modestly toward reducing income inequality. In light of this evidence, we can safely rule out increased schooling inequality as an explanation of the increased income inequality that took place in Mexico over the last decade.

Three broad hypotheses that do not hinge on changes in the distribution of education attainment are frequently advanced to explain the similar increases in earnings inequality experienced in Mexico and other countries.<sup>6</sup> These link the increase of earnings inequality to (i) the increased openness of the economy, (ii) institutional changes in the labor market, and (iii) skill-biased technological change. The first of these hypotheses argues that as trade barriers are reduced, an economy is placed under increased competitive pressures to specialize along its lines of comparative advantage. A developed country that is relatively high skill-abundant, like the United States, will be induced to specialize in high skill- or education-intensive activities as its low-skill industries come under increased competitive pressure from low skill-abundant, low-wage countries.

This explanation has several problems when applied to the United States, and becomes even less persuasive when applied to Mexico. Mexico greatly liberalized its trade regime since 1984. However, the reduction of its trade barriers has mostly been visa-vis imports from the developed countries, notably the United States and Canada, whose share in total Mexican merchandise imports increased from 68 percent in 1985 to 73 percent in 1993 (and to 77.5 percent in 1996). Since Mexico is a low skill-abundant country compared to its two northern neighbors, it would be expected that the liberalization of trade Would have induced a specialization pattern that would raise the relative demand (and hence wages) for the lesser educated members of the labor force. This did not happen. Instead, the increase in earnings inequality observed in Mexico is identical to that observed in the United States: less educated workers experienced real wage declines, while highly educated workers experienced real wage improvements. 7

- 6 See, for example, the Symposium on Wage Inequality published in Journal of Economic Perspectives (1997) and the Symposium on "How International Exchange, Technology and Institutions Affect Workers" published in The World Bank Economic Review (1997).

- 7 The trade-based explanation may still be relevant to the extent that greater openness facilitates the transfer of ideas and technology, which is identified below as the more persuasive explanation of the increase in earnings inequality. A variant on the globalization/technology nexus explanation, advanced by Feenstra and Hanson (1994), involves outsourcing behavior where multinational enterprises in the developed country relocate their lower skill-intensive activities to the less skill-abundant developed countries. However, what is a low skill activity in the United States may be a high-skill activity in Mexico, which could explain the identical evolution of earnings inequality in both countries.
9 The second explanation revolves around institutional changes such as reductions in the minimum wage, the decreasing strength of trade unions and the declining share of state-owned enterprises. The existence of a binding minimum wage, for example, truncates the lower end of the wage distribution. As the minimum wage is allowed to erode away, say through inflation, it becomes less binding by moving further down the low end of the wage distribution, with the result that, _ceteris paribus,_ a higher share of wages will lie below the previous minimum wage level. That translates into an increased dispersion in wages and earnings. Similarly, strong trade unions have often been found to exert an egalitarian effect on the wage distribution, while at the same time commanding a wage premium for union members. Any waning of union strength, as happened in the United States over the last two decades, therefore would contribute to an increase in wage dispersion. A review of institutional developments in the Mexican labor market by Hemrndez et al (1998) showed that these factors may have contributed to a higher wage dispersion. Most important in this regard was the apparent decline in union strength, in part due to the privatization of public enterprises during the early 1990s. That review also showed that the real decline of minimum wages since the early 1980s may have had an impact as well, but mainly confined to wages in the primary sector.

Perhaps the most persuasive explanation, both for the United States and Mexico, is that which links earnings inequality to skill-biased technological changes that raise the relative demand for higher-skilled labor. According to the typology used by Johnson (1997), the type of technological change that drives up the wages of more highly skilled workers and drives down those of less skilled workers -- as occurred in both the United States and Mexico -- is extensive skill-biased technological change. Under this type of technological change, skilled workers become more efficient in jobs that were traditionally performed by unskilled workers. A demand/supply analysis in Hernandez et al (1998) provides support for this explanation in the case of Mexico: it showed that secular changes in demand for workers differentiated by education level were the dominant force behind recent adjustments in the Mexican labor market, with the market for more educated workers dominated by intra-sectoral increases in demand, and for less educated workers by intra-sectoral decreases in demand, independent of gender and experience. That outcome suggests that the rise in wage dispersion originates from changes in the intra-sectoral production structure, which favors educated versus uneducated workers, rather than from changing trade patterns, which would affect the demand for labor differently across sectors.8

# C. Some Background Facts on Education Spending

Mexico's overall spending on education, as a share of GDP, is slightly above the OECD average and compares favorably with education spending levels in other developing countries. Total spending per student in Mexico increased steeply in the second half of the 1980s and early 1990s, even though the total student population increased, from 24 million in 1985 to 27 mnillion in 1995. Part of this increase reflects a sThese findings correlate with earlier findings for Mexico (Cragg and Epelbaum, 1994) as well as for Chile, following its trade liberalization program (Robbins, 1994).
10 rebound from the expenditure cuts that were made in response to the debt crisis in 1982. By 1994, however, total spending on education had risen to 5.4 percent of GDP, or almost a full percentage point above its previous peak of 4.5 percent reached in 1982.

<!-- Start of picture text --> Figure 3<br>MEXICO<br>Education Spending per Student Capita<br>3500.00 -<br>8 3000.00 Prvate<br>o 2500.00<br>Z2000.00-<br>1500.00- Muipa<br>aC<br>1000.00<br>O 500.00 Federal<br><!-- End of picture text --> Source: Informe de Gobiemo, 1989 and 1997.

Figure 3 describes the evolution of funding for education in Mexico since the early 1980s. Private spending represenited less than 10 percent of total expenditures in education in 1987, and has fallen to below 5 percent in recent years. (This figure somewhat underestimates total private costs, which, with some adjustments noted in the Annex could be around 27% of total education spending.) Similarly, the share of state and municipal spending peaked at 17% of total spending in 1990, but since then also declined to less than 10 percent of total spending. The federal government, on the other hand, currently accounts for 87 percent of total sector spending. These figures are not far out of line with those from an OECD review of education expenditures, which indicated that in 1994, about 19 percent of spending on education in Mexico came from private sources, compared to a country average of 13 percent for the whole of the OECD.<sup>9</sup> Mexico does not stand out particularly in the preceding comparison. As in most countries, the public sector directly or indirectly finances the lion's share of education expenditures. Mexico does stand out in contrast to its OECD partners, however, when these expenditures are disaggregated by level of instruction. As shown in OECD (1998, pg. 97) the ratio of spending per student at the tertiary level compared to spending at the primary level exceeded 500 percent in 1994 and was the highest among OECD countries. (The ratio in Korea, for example, is close to the OECD average of 264 percent, or less than half the Mexican ratio.)

> 9These figures comprise total expenditures on education, including privately purchased materials, whereas the earlier figures shown in Table 3 are identical to the what the OECD expenditure review refers to as direct spending on educational institutions.
11

**Table** 4: **Federal Education Spending per Student by Level**

||F<br>**primary**|ederal Spen<br>(constant<br>**secondary**|ding per Stu<br>1994 Pesos)<br>**preparator**|dent<br> <br>**y university**|(as sh<br>**prim.**|are spent<br>**second.**|on Pri<br>**prep.**|mary)<br>**univ.**|
|---|---|---|---|---|---|---|---|---|
|1980|1166.1|2571.8|4823.7|8667.3|1|2.2|4.1|7.4|
|1981|1447.6|2790.6|6156.9|11544.0|1|1.9|4.3|8.0|
|1982|935.8|2027.3|4586.4|10061.0|1|2.2|4.9|10.8|
|1983|710.5|1562.0|2714.7|6451.4|1|2.2|3.8|9.1|
|1984|691.1|1644.3|3108.4|6544.2|1|2.4|4.5|9.5|
|1985|715.0|1473.3|3582.2|7174.8|1|2.1|5.0|10.0|
|1986|961.5|2094.6|3329.3|11686.2|'|2.2|3.5|12.2|
|1987|683.7|1308.3|3364.0|6334.3|1|1.9|4.9|9.3|
|1988|665.1|1303.0|3423.0|6520.2|1|2.0|5.1|9.8|
|1989|734.0|1438.9|3756.0|6176.3|1|2.0|_5.1_|8.4|
|1990|808.4|1685.8|3502.8|6473.5|1|2.1|4.3|8.0|
|1991|1011.4|1942.6|3772.9|6898.3|1|1.9|3.7|6.8|
|1992|1285.9|2318.7|3384.3|9313.2|1|1.8|2.6|7.2|
|1993|1584.6|2568.4|4304.6|11637.2|1|1.6|2.7|7.3|
|1994|1731.3|3139.4|5215.1|13253.0|1|1.8|3.1|7.7|
|1995|1679.0|2511.0|4508.1|11202.3|1|1.5|2.7|6.7|
|1996|1647.7|2464.2|4442.9|11328.5|1|_1.5_|2.7|6.9|
|1997|1811.9|2709.7|4882.1|12692.2|1|1.5|2.7|7.0|

Source: Presidencia de la Republica, Primer Informe de Gobiemo, 1989, and Tercer Informe de Gobiemo, 1997.

The great disparity in per-student spending at different education levels in Mexico is also reflected in Table 4, which only refers to federal expenditures. This Table also shows, however, that the evolution of public spending on education in Mexico has become more egalitarian across different schooling categories over time. In the early 1980s, the amount of federal spending per university student averaged 10 times the amount spent per primary student. This ratio fell to around 7 times in the early 1 990s. Federal spending on the other levels relative to the primary level indicate a similar decline, even though the absolute amounts increased at all levels. In other words, even though the recent pattern of spending on education in Mexico exhibited a highly uneven bias in favor of tertiary education relative to other categories, the pattern of spending in earlier periods exhibited and even greater bias.

# D. **The Rates of Return on Investments** in **Education**

One way to assess the economic merits of the preceding spending patterns, considered as investments in education, is by comparing their relative rates of return. This section compares the rates of return to education as derived from several human capital earnings functions. These were estimated with data from two income-expenditure surveys (ENIGH) carried out by the National Statistical Institute (INEGI) in the third quarters of 1984 and 1994. These two survey years provide an excellent setting for comparisons: first, both years can be considered macroeconomically comparable in that the economy is neither in recession nor booming. Secondly, both years are almost equidistant in time from the major stabilization and structural reform measures implemented
12 by the Mexican Government in the latter half of the 1980s. They are especially suitable, therefore, for making 'before and after' comparisons.

The ENIGH surveys identify the educational attainment, income received and number of hours worked per week by each family member.'<sup>0</sup> Income is differentiated into about 25 items, which were aggregated into three broad categories: (i) wage and salary income, (ii) current monetary income, which includes wages and salaries, income from self-employment, property income and rents, monetary transfers and income from financial assets, and (iii) total current income, which includes all of the above items, plus non-monetized income such as imputed rent, in-kind transfers and stock dividends. In contrast to this disaggregation of income sources, the ENIGH surveys do not differentiate the number of hours worked per week by activity. The rates of return calculated below are based on two measures of earnings per hour: the wage rate, which refers to wage and salary earnings per week, divided by the total number of hours worked per week, and the monetary earnings rate, which refers to current monetary income divided by the same number of hours worked per week.

Tables 5 and 6 present the private and the public rates of return on investments in education in Mexico. The method used to estimate these rates of return is explained in detail in the Annex. The distinction between public and private rates of return in this context centers around who bears the cost of financing the investment in education: in both cases, the benefits of an additional year of schooling are reflected in the stream of additional earnings that accrue to an individual as a result of that additional education. The rate of return to education is then the discount rate that equates the present value of this stream of additional earnings to the present value of the costs incurred. When only private costs are considered in this calculation, it is tenned the private rate of return, and when all public and private costs are considered, it is termed the social rate of retum.

**Table 5: Private Rates of Return to Schooling in Mexico**

(Private cost of education is 100% of foregone full year's earnings; KP = 1.)

||Wage|Earners|Monetary Inco|me Recipients|
|---|---|---|---|---|
||1984|1994|1984|1994|
|Average "Mincerian"<br>_by schooling level_|15.2%|16.7%|<br>14.6%|17.2%|
|1 - primary complete|16.9%|13.8%|14.7%|14.3%|
|2 - secondary complete|13.9%|16.7%|14.5%|16.0%|
|3 - preparatory complete|_15.5%_|18.2%|14.4%|19.2%|
|4 - university and above|10.3%|19.9%|12.8%|20.6%|

Source: Tables Aland A2, using the method described in the Annex.

°Several sources of potential bias in the data base require attention: first, casual evidence indicates that the sample of families included in the ENIGH surveys is truncated in that the very rich and the very poor appear to be underrepresented. Indigenous groups, which are estimated at around 1o percent of Mexico's population, also appear underrepresented. Finally, there appear to have been some sampling problems involving the 1984 survey (the first year the survey was conducted by INEGI), which may have affected its comparability with the 1994 survey.
13 Two phenomena about the private rates of return draw attention in Table 5: the first is that the overall rate of return to education has increased between 1984 and 1994, as seen from the "Mincerian" rates of return. This is a direct consequence of the increased dispersion in wages that took place over that period. Secondly, the rates of return for different levels of schooling have changed in ranking. In 1984, the lower levels of education uniformly yielded greater rates of return than investments in higher levels of education. This ranking is completely reversed in 1994, with the private rates of return to primary education declining significantly below the rates of return to higher education, which almost doubled."<sup>1</sup>

**Table** 6: **Social Rates of** Return to Schooling in Mexico

||Wage E|arners|Monetary Inco|me Recipients|
|---|---|---|---|---|
|_Schooling Level_|**1984**|**1994**|**1984**|**1994**|
|l-priinarycomplete|_15.5%_|11.3%|<br>13.7%|11.8%|
|2 - secondary complete|12.4%|13.0%|<br>13.1%|12.7%|
|3 - preparatory complete|12.9%|13.2%|<br>12.2%|14.4%|
|44-university and above|7.6%|13.2%|<br>9.6%|13.9%|

Source: Tables Aland A2, using the method described in the Annex.

As in the case of the private rates of return, the social rates in Table 6 also indicate a decline in the rate of return for primary education and increases in the rates of returns for higher education during the decade between 1984 and 1994. A noteworthy difference to the private rates of return, however, is that the social rates of return exhibit a much lower dispersion across schooling levels in 1994 than in 1984. That is, the social rates of return associated with different investments are much closer together, which, in a standard capital market context, suggests a decline in market segmentation and, thus, a more efficient allocation of investment resources in education.

# E. A **Policy Dilemma**

A general efficiency criterion for investing is that resources should be first invested in those activities that yield the highest rate of return until the point where the marginal rate of return drops to the level of the activity with the next highest rate of return. Barring any corner solutions and assuming that investments in education exhibit decreasing marginal rates of return, this rule will have the effect of equating rates of return across different activities. Suppose that the government were following this efficiency rule in its allocation of public resources in education in the face of increased wage dispersion. As shown in the Annex, that would mean that the pattern of public spending in education would have to adjust in the same direction as the private rates of " Theprivate rates of return in Table 5 pertaining to 1984 are very similar to the private rates reported for Mexico in Psacharopoulos (1994a). The main difference arises with regard to primary education, where his paper reports a significantly higher return. The reason is because Psacharopouloa **s** sumes that the foregon **e** arnings from attending primary school are roughly half the figure used in our calculations, which are based on Annex Table A3. Psacharopoulos' lower assumption is mean **t** o adjust for the very low opportunity cost of young children attending primary school.
14 return to education. In other words, as the dispersion of wages increases, the private rates of return on investments in higher education increase. Other things equal, that also raises the social rates of return for higher education levels in the same proportion. Therefore, to prevent a misalignment of the social rates of return in education, the government would have to shift resources away from primary education (which raises its rate of return) and toward higher education (thereby causing a compensating reduction in its marginal rate of return).

The preceding response, based on efficiency considerations, would conflict with equity considerations in the short run, though not necessarily in terms of long term consequences. Insofar as the primary level encompasses a higher proportion of individuals from poor households than do higher education levels, the efficient response would change the pattern of direct spending toward more affluent individuals. Moreover, that change in spending would come about after the already existing income disparities across households had been aggravated by the movement in relative wages. Over time, the increased spending on higher education leads to a higher relative supply of more educated workers, which depresses their relative wage and, thereby, has an equalizing effect on total earnings. That equalizing consequence occurs in the long run, however, and would have little impact on the earnings of the currently affected generation of workers.

A surprising thing about Mexico over the last decade is that even though public spending has become more evenly distributed, the social rates of return in Table 6 also have become more uniform in 1994 compared to 1984. The answer to this puzzle lies in the very distorted pattern of education spending that existed at the beginning of the period. Public education spending in the early 1980s was very skewed toward higher education, which exhibited the lowest rates of return. That is, it was both inefficient and inequitable.'<sup>2</sup> By moving toward a more even distribution of per capita spending across different levels, equity was improved. At the same time, the external environment changed in a manner that raised the relative return to higher education, thereby tending to make more efficient what had initially been an inefficient allocation of resources.

As the social rates of return to education become equalized, however, the opportunities for achieving gains by undoing past mistakes will be exhausted. That means that policymakers will no longer be able to evade this equity-efficiency tradeoff, assuming that the rate of skill-biased technological change continues as before. So long as education spending remains concentrated at the federal government level, that same government will have to decide whether to respond to exogenous increases in the rates of return to higher education by shifting more resources toward higher education at the expense of increased inequity in spending, or by maintaining a more equitable spending distribution at the expense of increased inefficiency.

> 12 This observation isconsistent with earlier findings by Elias (1992), which indicated that growth in the "quality" of the labor force contributed little to Mexico's overall economic growth in the 1960s and 1970s, compared with other Latin American countries.
15 There is no easy response to this dilemma. The politically least controversial response of assigning more resources to higher education through a higher overall budget to education runs into fiscal constraints."<sup>3</sup> Barring more public resources, the only option for expanding of investment in higher education (desired on efficiency grounds) without cutting public funding for primary education is by attracting greater private sector participation.

To facilitate greater private participation, it is useful to distinguish more clearly the roles of the private and public sectors. The classic assignment of responsibilities limits the public sector's involvement to the provision of public goods, as well as correction for market failures and externalities. In that context, it is often argued that the positive externalities from education are highest at the primary level and progressively decline at the higher levels; Schultz (1988). That is, at higher education levels, the individuals receiving the education capture a progressively larger share of the total social benefits yielded from the education in the form of higher wages. That being the case, there is less of a risk that private individuals left to their own devices would underinvest from a social viewpoint in higher education than that they would underinvest in primary education. The externalities from different levels of education are difficult to measure and compare empirically. However, if the rationale for state intervention in the provision of higher education services is based on the argument that rates of return were too low to induce the right amount of investment from the private sector, that rationale has certainly become less compelling with the significant increases in private rates of return observed in recent years.

The options for greater private sector participation in higher education are many. They range from greater participation in the funding of education services to greater participation in the direct provision of services.<sup>14</sup> At the very least, the rise in private rates of return for higher education makes a compelling case for increasing the level of cost-recovery in higher education, independently of whether it is the State or the private sector that provides those services. The lack of long-term financing for private investments in higher education represents an important obstacle to the implementation of this solution. That obstacle is rooted in a systemic market failure (due, among other, to bans on indentured servitude) that poses problems in most countries, but is especially pronounced in Mexico on account of its very weak financial system. The proper role of government is precisely to correct or compensate for such market failures. A promising way to correct these market failures in Mexico is through student loan programs, or means-tested financial aid and scholarship programs. These programs are currently almost non-existent in Mexico, as the public sector has relied mainly on the direct, costfree provision of higher education services. The scholarship programs suggested here as an alternative promise to yield a more efficient resource allocation than a cost-free

**3 A** sense of the potential magnitude of these fiscal costs can be obtained from **OECD (1997, Chart B 1.3). It** estimates that raising Mexico's enrollment ratios in tertiary education to the **OECD** average **level,** would involve an increase of expenditures on educational institutions by 1.4 percent of **GDP.** This is almost twice the size of the fiscal revenue shock (estimated at **0.8 percent of GDP)** caused by **the** decline of oil prices in **late 1997 and early 1998.**

**14 See OECD (1997,** pg. **54) for a** list **of various options for the funding of tertiary institutions.**
16 provision of services. Although such programs have rarely been devoid of subsidy components wherever they have been implemented worldwide, that subsidy is more closely targeted to the source of the market failure."<sup>5</sup> Looking toward the future, there are two developments that bode well for the distribution of income in Mexico in future years. One is that Mexico has gotten past "Ram's turning point" (section B), so that further advances in the average schooling level should result in a more even distribution of education across the labor force. Other things being equal, that should translate into a more equal distribution of earnings. The other development is that the supply of workers with higher education is increasing, which is the desired market response to the increased wage premium on higher education. The increasing supply of more educated workers should eventually reduce the wage premium received by such workers and, thus, also tend to equalize the earnings distribution. In view of the long gestation periods associated with investments in education, however, the income-equalizing dynamics in both cases operate with a long-term horizon. Any reallocations in education expenditures, therefore, should be made with that horizon in mind and not be seen as substitutes for income transfers designed to compensate for current income inequalities.

# **F. Summary**

This chapter arrived at six principal conclusions and one recommendation:

- The accumulation of human capital, as proxied by education attainment, does not appear to be among the factors responsible for Mexico's disappointing growth performance since the early 1980s, but rather stands out positively in historical and international comparisons.

- Mexico experienced a pronounced increase in earnings inequality during the period 1984-94, in spite of a rapid expansion of education attainment levels that exerted an equalizing impact on earnings. Of the various hypotheses that have been advanced to explain the increased earnings inequality in Mexico as well as other developing and developed countries, the most persuasive appears to be that it is caused by an increased rate of skill-biased technological change, whose transmission to developing countries may have been facilitated by the increased openness of those economies.

- The preceding analysis contains an interesting parallel to Beristain's (1991) analysis of options to meet the rapidly increasing demand for higher education foreseen in Mexico for the 1990s. In his analysis, the demand for higher education emerges from exogenous demographic pressures. In this paper, the increased demand results from exogenous increases in the dispersion of wages observed in Mexico and other countries. Among the response options outlined by Beristain, the first is to maintain the status quo, which mainly involves the provision of services by public universities on a cost-free basis. The second option is to charge an increasing share of education costs to beneficiaries, while keeping the provision of service in public hands. The third option goes one step further by transferring an increasing portion of the provision of services to private hands. He concludes that Mexico's fiscal constraints and political considerations render the first option non-viable, so that increased demand for university education is best accomodated through a response that involves a combination of the second and third option. The conclusions of this paper also point in the same direction.
17

- The increased earnings inequality is associated closely with a higher dispersion of the average wages received by workers with different schooling attainment. This had the consequence, in turn, of raising the private rates of return to higher levels of education; in effect reversing the traditional pattern of rates of return, where the highest rates are reported for the primary level. The social rates of return also exhibit this reversal in the relative magnitude of the rates of return. In contrast to the increased dispersion of the private rates, however, the social rates of return across different schooling levels have become more uniform in 1994, compared with 1984. This suggests that the assignment of education resources has become more efficient.

- Government spending on education rose significantly in the early 1990s. It also became more equitably distributed as per-student spending in higher education declined markedly compared to per-student spending at the primary level. Spending on education continues to be very concentrated in the public sector, especially at the federal level.

- That a more equitable distribution of public spending on education was achieved simultaneously with a more efficient spending pattern -- as reflected in the reduced dispersion of social rates of return -- is very surprising. Normally one expects a tradeoff between equity and efficiency in this context. What explains this result is that the spending pattern in the early 1980s was both highly inefficient and inequitable. So reduced spending at higher levels made for a more equitable distribution of resources, while simultaneous changes in the external environment that raised the returns on higher schooling levels, caused the allocation of resources (which continues to be biased toward higher education) to become more efficient.

- As the social rates of return are equalized, the possibilities of exploiting initial inequities and inefficiencies will become exhausted. Furthermore, there is little reason to expect the pace of technological change to abate, so that wage dispersion may well continue to increase. This will continue to raise the rates of return for higher education, warranting the shift of more resources toward higher education on the basis of efficiency considerations, which ultimately translate into productivity considerations. To the extent that resource shifts in that direction are thwarted by equity considerations, output and productivity growth will suffer.

- The recommended solution to the preceding dilemma is for the government to progressively pass on a greater share of the costs of higher education to its direct beneficiaries, while facilitating the private absorption of those costs through student loan programs designed to correct market failures in the financial sector.