Pareto-Improving Education Subsidies with Financial Frictions and Heterogenous Ability

Previous literature has shown that missing credit or insurance markets do not necessarily provide an efficiency-based argument for educational subsidies, starting with a laissez faire competitive equilibrium. We show that they do, provided learning abilities vary idiosyncratically. In an OLG economy with ability heterogeneity and missing financial markets, we prove: (a) every competitive equilibrium is interim Pareto dominated (and ex post Pareto dominated with sufficient parental altruism) by a policy providing education subsidies financed by income taxes, and (b) transfers conditional on educational investments similarly dominate unconditional transfers. The policies also result in macroeconomic improvements (higher per capita income and upward mobility) Boston University and University of Bayreuth respectively. We acknowledge helpful comments by Roland Bénabou, participants of the Oslo THRED conference in June 2013, the Ascea Summer School in Development Economics 2014 and the Verein für Socialpolitik annual conference 2014 as well as seminar participants at Boston University, Michigan State University, University of Bayreuth, University of Münster and University of Turku. We thank Brant Abbott for providing us with details of the nature of inter vivos transfers in Abbott et al. (2013). We are also grateful to Marcello d’Amato for numerous discussions and ideas concerning occupational choice and role of the welfare state.