How Important is Human Capital? A Quantitative Theory Assessment of World Income Inequality

We develop a quantitative theory of human capital investment in order to evaluate the magnitude of cross-country differences in total factor productivity (TFP) that explains the variation in per-capita incomes across countries. We build a heterogeneousagent economy with cross-sectional variation in ability, schooling, and expenditures on schooling quality. In our theory, the parameters governing human capital production and random ability process have important implications for a set of cross-sectional statistics − Mincer return, variance of earnings, variance of schooling, and intergenerational correlation of earnings. These restrictions of the theory and U.S. household data are used to pin down the key parameters driving the quantitative implications of the theory. Our main finding is that human capital accumulation strongly amplifies TFP differences across countries. In particular, we find an elasticity of output per worker with respect to TFP of 2.8: a 3-fold difference in TFP explains a 20-fold difference in output per worker. We argue that the cross-country differences in human capital implied by the theory are consistent with a wide array of evidence including earnings of immigrants in the United States, average mincer returns across countries, and the relationship between average years of schooling and per-capita income across countries. The theory implies that using Mincer returns to measure human capital understates differences across countries by a factor of 2.