Capital Market Failure, Adverse Selection and Equity Financing of Higher Education
Tilburg University, CentER; Netspar; University of Amsterdam - Amsterdam School of Economics (ASE); CESifo (Center for Economic Studies and Ifo Institute for Economic Research)
Sweder Van Wijnbergen
Universiteit van Amsterdam; Tinbergen Institute; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
Tinbergen Institute Discussion Paper No. TI 05-037/3
We apply theories of capital market failure to analyze optimal financing of risky higher education. In the market solution, students can only finance their education through debt. There is underinvestment in human capital, because some students with socially profitable investments in human capital will not invest in education due to adverse selection problems in debt markets and because insurance markets for human capital related risk are absent. Legal limitations on the use of human capital in financial contracts cause this underinvestment; without them private markets would optimally finance these risky investments through equity rather than debt and supply income insurance. The government, however, can circumvent this problem and implement equity and insurance contracts through the tax system using a graduate tax. This paper shows that public equity financing of education coupled to provision of some income insurance is the optimal way to finance education when private markets fail due to adverse selection. We show that education subsidies to restore market inefficiencies are sub-optimal.
Number of Pages in PDF File: 28
Keywords: Human capital, capital market imperfections, credit rationing, financing risky investment, optimal education finance, graduate taxes, education subsidies
JEL Classification: H21, H24, H52, H81, I22, I28, J24working papers series
Date posted: April 19, 2005
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