Optimal Student Loans and Graduate Tax Under Moral Hazard and Adverse Selection

42 Pages Posted: 21 Jun 2013

See all articles by Robert J. Gary-Bobo

Robert J. Gary-Bobo

CREST ENSAE; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

Alain Trannoy

National Center for Scientific Research (CNRS) - Ecole des Hautes Etudes en Sciences Sociales (EHESS)

Multiple version iconThere are 2 versions of this paper

Date Written: June 2013

Abstract

We completely characterize the set of second-best optimal "menus" of student-loan contracts in a simple economy with risky labour-market outcomes, adverse selection, moral hazard and risk aversion. The model combines structured student loans and an elementary optimal income-tax problem à la Mirrlees. This combination can be called a graduate tax. There are two categories of second-best optima: the equal treatment and the separating allocations. The equal treatment case is obtained when the social weights of student types are close to their population frequencies; the expected utilities of different types are then equalized, conditional on the event of success on the labor market. But individuals are ex ante unequal because of differing probabilities of success, and ex post unequal, because the income tax trades off incentives and insurance (redistribution). In separating optima, the talented types bear more risk than the less-talented ones; they arise only if the social weight of the talented types is sufficiently high. The second-best optimal graduate tax provides incomplete insurance because of moral hazard; it typically involves cross-subsidies; generically, it cannot be decomposed as the sum of an optimal income tax depending only on earnings, and a loan repayment, depending only on education. Therefore, optimal loan repayments must be income-contingent.

Keywords: asymmetric information, higher education, mechanism design, optimal taxation, student loans

JEL Classification: D82, H21, I22, I24

Suggested Citation

Gary-Bobo, Robert J. and Trannoy, Alain, Optimal Student Loans and Graduate Tax Under Moral Hazard and Adverse Selection (June 2013). CEPR Discussion Paper No. DP9505. Available at SSRN: https://ssrn.com/abstract=2282959

Robert J. Gary-Bobo (Contact Author)

CREST ENSAE ( email )

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+33141176031 (Phone)

HOME PAGE: http://www.crest.fr/ses.php?user=3042

CESifo (Center for Economic Studies and Ifo Institute) ( email )

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Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Alain Trannoy

National Center for Scientific Research (CNRS) - Ecole des Hautes Etudes en Sciences Sociales (EHESS) ( email )

54, boulevard Raspail
Paris, 75006
France

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