Capital-Market Failure, Adverse Selection, and Equity Financing of Higher Education

Bas Jacobs and Sweder van Wijnbergen

FinanzArchiv: Public Finance Analysis, 2007, vol. 63, issue 1, 1-32

Abstract: We apply theories of capital-market failure to analyze optimal financing of risky higher education. In the market solution, students can only finance theireducation 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 by 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 suboptimal.

Keywords: human capital; capital-market imperfections; credit rationing; financing risky investment; optimal education financing; graduate taxes; education subsidies (search for similar items in EconPapers)
JEL-codes: H21 H24 H52 H81 I22 I28 J24 (search for similar items in EconPapers)
Date: 2007
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (19)

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DOI: 10.1628/001522107X186683

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