Cognitive Ability, Heterogeneity, Endogeneity and Returns to Schooling in Chile: Outcomes of the 1981 Capitation Grant Scheme

The objective of this paper is to exploit the unique information on cognitive ability contained in the International Adult Literacy Survey (IALS) data, for an in depth examination of the importance of cognitive skills for heterogeneous individuals using: (a) a quantile regression methodology which allows for an interaction between schooling and cognitive skills and (b) Instrumental Variables estimation to evaluate the relationship between quantity and quality of schooling outcomes following the 1981 “vouchers” reform in Chile. On average, inclusion of the direct measure of cognitive ability reduces the return to schooling by about 25 percent – roughly equivalent to two additional years of schooling, while a one standard deviation increase in the score increases earnings by 15-20 percent. However, for those in the lowest earnings/ability quantile, education qualifications at any education level do not contribute to earnings; rather cognitive ability is the key to higher earnings. On the other hand, those in high quantiles (higher unobserved ability) benefit much more from acquiring more schooling, and from the interaction of schooling and cognitive ability. Using a binary instrument based on the 1981 reform, we find that the main beneficiaries of the reform were those who at the time were entering primary school or who were existing pupils in basic education. For this treated group of pupils, only a small part of the estimated return to schooling is due to classical ability bias. However, once the treated group is expanded to include secondary school students, the pure return to schooling decreases dramatically while the return to cognitive skills is very large, suggesting that most of the estimated return from a Mincerian earnings function is due to classical ability bias. JEL: I21, J31