The Effect of Polity on the Returns to Education
Rosalie Dieleman
Student number: 343454
Erasmus University Rotterdam
Erasmus School of Economics - Department of Economics
June 2015
Bachelor’s Thesis
Supervised by Prof. Dr. A.J. Dur
TABLE OF CONTENTS
1.INTRODUCTION
2.LITERATURE REVIEW
2.1.THE RELATIONSHIP BETWEEN EDUCATION AND GROWTH
2.1.1.Growth Models
2.1.2.Empirical Results
2.2.THE RELATIONSHIP BETWEEN GOVERNMENT TYPE AND GROWTH
2.2.1.Theory
2.2.2.Empirical Results
2.3.DISCUSSION OF THE LITERATURE
3.DATA
4.METHODOLOGY
4.1.THE MODEL
4.2.ASSUMPTIONS FOR ORDINARY LEAST SQUARES
4.3.INTERACTION TERM
5.RESULTS
5.1.DESCRIPTIVE STATISTICS
5.2.CORRELATIONS
5.3.ESTIMATION RESULTS
5.3.1.Simple model with Schooling and Polity
5.3.2.Estimation results of the full model
6.DISCUSSION
7.CONCLUDING
8.BIBLIOGRAPHY
9.APPENDIX
9.1Countries in dataset 1: 1970-2010
9.2Countries in dataset 2: 1990-2010
9.3Histograms dataset 1: 1970-2010
9.3.1Histogram GDP
9.3.2Histogram gdp
9.3.3Histogram TFP
9.3.4Histogram CS
9.3.5Histogram cs
9.3.6Histogram PLT
9.3.7Histogram EDU
9.4Histograms dataset 2: 1990-2010
9.4.1Histogram GDP
9.4.2Histogram gdp
9.4.3Histogram TFP
9.4.4Histogram CS
9.4.5Histogram cs
9.4.6Histogram PLT
9.4.7Histogram EDU
- INTRODUCTION
All over the world, education is considered essential for human and economic development. In developed countries like the Netherlands, governments invest large parts of their budget in science and education to boost economic growth and keep industries innovating. In the Netherlands the ministry of Education, Culture and Science spends over 10 percent of the government budget; 32.9 of the total 259 billion Euros government spending in 2013 (Tweede Kamer der Staten-Generaal, 2015). Prime Minister Mark Rutte, in a speech about the Dutch economy, talked about the importance of the “knowledge economy” for the Netherlands ( 2013). He mentioned the leading role of the Netherlands when it comes to food technology and water management, as well as the fact that “Eindhoven is the most innovative city in the world”. A high level of overall schooling and specialized universities plays a big role in this. This high level of education is one of the factors that play a role in the success of the Dutch economy; the Netherlands is ranked 8th in the World Economic Forum ranking of competitive economies ( 2015).
Governments of developed countries acknowledge the importance of a high level of human capital and invest to keep the education level within their country high. On the other hand, efforts are being made to increase education in developing countries. Probably the best-known example of this aim are the “millennium development goals”. The United Nations set these goals during the Millennium Summit of 2000. Goal number one of this list is to “eradicate extreme poverty and hunger”, the second goal is to “achieve universal primary education” ( 2015). These goals were to be achieved by 2015. Sadly, we are still far from achieving this goal; the UN reports there were still 58 million children of primary school age were out of school in 2012. However, the percentage of children receiving education in developing areas has risen from 82 per cent in 1999 to 90 percent in 2010. The percentage of children attending primary school has never in history been this high. This is achieved by the investment of parents, private investors, governments and development organizations like Unicef, who all want to invest in the future of children.
So why is it exactly that a high level of education is considered so crucial for higher welfare? Of course, we all find it important that people can develop themselves. However, the main reason that in both economics and politics education is often discussed is that higher human capital is believed to be a factor that increases economic growth. Many economic growth models and studies have shown a positive effect of education on economic growth. From 1966 to 2006, economic output has increased by 3.5 percent per year while the productivity of labour increased by about 2.4 percent per year (Dickens et all., 2006). Thirteen to thirty percent of this increase in labour productivity is believed to be due to increasing education levels (Dickens et all., 2006). Education is thus believed to play a substantial role in economic growth. There are a number of reasons why educated people are believed to be more productive. For instance the fact that they usually are more adaptable and mobile, quickly learn how to use new technology and are fast in learning new tasks and skills. An educated labour force needs less supervision and guidance, and is usually more creative in solving problems within an organization. An important feature of benefits from education is that they tend to spill over. People learn from each other, skills induce more skills and firms adapt their level of technology and capital to the skill level of the available labour force.
Therefore, the relationship between education and economic growth is a relevant topic for every country’s policy decisions. It is an equally or maybe even more important consideration for developing countries and world development organizations. If more and better education would lead to higher economic growth, it could be especially beneficial to invest in education in developing countries. Different development organizations like Oxfam Novib invest in projects to improve education, building schools, and stimulating parent to send their children to school. But will this have the desired effect? Does investment in education have the same effect in different circumstances?
The type of government and institutions that are present in a country can also have a substantial effect on the economy. When we look back in history, it is clear how much influence governments can have on the economic situation within a country. It can even affect several countries or an entire continent. Think for instance about the effect that feudalism had on the welfare of the average citizen during the middle ages. More recent history also proves the effect of governments on the economy, when communist governments in eastern Europe left their economies in ruins. Robert Barro (1994) analyzed the effect of institutions on economic growth, and found that factors like rule of law, free markets and small government consumption have a positive effect on economic growth. These aspects can more often be found in democratic governments rather than in autocratic governments.
All institutions in place in a country can affect the economic situation. These institutions include factors like political freedom, freedom of speech and economic freedom. This includes for instance the freedom to start up your own company. When highly educated people are not restricted in their ambitions to start up successful businesses, chances are they will contribute to the economy more than when restrictive regulation refrains them from doing this. The same holds for education; if the institutional climate of a country obstructs educated people to be innovative and effectively implement necessary changes, the payoff of investing in education will probably not be very high. Such circumstances might lead to a “brain drain”, a flight of human capital to places where human capital is valued higher. Because this interplay of different elements can all affect the result of investment in human capital, it is important to realize that investment in education may not always have the same outcome. Therefore, this paper will research whether the effect of education on growth differs between countries with different government types. The research question of this paper is: Does the polity of a country affect the economic payoff of education?
The effect of government type on overall economic growth is a controversial subject in economic theory. Economists have different views on this topic. One of the theories regarding this topic was introduced by the well-known twentieth century economist Milton Friedman, who believed that political freedom and economic freedom are mutually reinforcing (Friedman, 1962). His argument is that economic freedom is necessary for political freedom and the other way around. A high level of political freedom stimulates growth of economic freedom. In the liberal economic theory, economic freedom fosters economic growth. Friedman believed that either one cannot exist without the other. When applying this theory to the topic of this paper, the payoff of education, this implies that the payoff of education will be higher in a country with more political freedom. These factors are more likely to be present in a democratic state. The first hypothesis therefore is: Democratic countries will have a higher return to education than more autocratic countries.
Authoritarian regimes, however, can also have a liberal economy with economic freedom and protection for private property. Not all authoritarian regimes involve central planning, some autocratic regimes have actually increased economic freedoms. Example from the last century where the Pinochet government in Chile and the Shah’s government in Iran. China nowadays is a good example of an economy that has an autocratic regime and booming economic growth. Economist Paul Collier has therefore argued that authoritarianism can in fact stimulate growth (Collier, 2007). He argues that this can especially be the case in an ethnically homogenous society. There are also some features of democratic governments that are impediments to growth, which autocratic governments may be able to avoid. For instance the influence of pressure and interest groups in political decision-making, and the redistribution of income from rich to poor. Therefore, the second hypothesis will be: Autocratic countries will have a higher return to education than more democratic countries.
- LITERATURE REVIEW
This section will give a brief overview of the relevant existing literature. The first section will summarize some of the main theories and empirical findings on the relationship between education and economic growth. This be followed by a discussion of the relevant literature and empirical result of research on the relationship between the effect of government type on economic growth.
2.1. THE RELATIONSHIP BETWEEN EDUCATION AND GROWTH
Economists have long researched the relationship between education and economic growth. Many of them emphasized the importance of human capital in the development of a country and its economy. Analysing the effect of education is a difficult field of research because in many countries data on education is lacking. Even if data is available, it is still questionable what variables to use: primary education, secondary education, total years of education, or is some qualitative measure instead of a quantitative measure required? Some of the relevant results will be discussed in the following section.
2.1.1. Growth Models
In 1956 Nobel Prize winner Robert Solow published his article “A contribution to the Theory of Economic growth”; the growth theory presented in this article became one of the most influential growth models in modern economics. The “Solow growth model”, also called “neoclassical growth model”, breaks economic growth down in three main factors: capital accumulation, labour growth and technological progress. Economic output will increase with any of these factors. However, Solow argues that economies eventually will reach a “steady state”, in which output increases only with the rate of technological progress (Solow, 1956). Eventually, technological progress is what keeps output growing in the long term. Solow noted that higher levels of education contributed to the growth of technological progress. Therefore, technological progress is likely to be higher when investment in human capital and research is high.
Paul M. Romer (1990) introduced his own growth model, in which economic growth is driven by technological change. Romer’s model is similar to the Solow model: it is a neoclassical growth model that puts technological progress at the heart of economic growth. He argues that technological change leads to continued capital accumulation, because capital needs to keep up with the changes in technology, and this mechanism of increasing capital stock accounts for a large part of the growth in labor productivity. Whereas technological change is exogenous in the Solow model, Romer’s model is augmented with endogenous technological change. He incorporates the fact that a majority of the changes in technology come about by intentional actions of individuals moved by market incentives. One of the main outcomes of this model is that economies that have a larger total stock of human capital will grow faster (Romer, 1990).
Paul Romer also commented that the Solow model could not explain the high correlation between the growth of output and the growth of capital stocks, and also the fact that sometimes a negative correlation between economic growth and labour force growth existed. Gregory Mankiw, David Romer and David Weil came up with an answer to this. They performed empirical research to see whether the Solow model would fit the real-life data. They found that when the Solow framework was extended to incorporate human capital and physical capital as separate factors of production, that this “augmented” Solow model provided a good fit for the used cross-country data (Mankiw, et al., 1992). They also showed that the negative relationship between population growth and economic growth, happened to be the case in countries that had relatively little growth of human capital. According to their research, the augmented Solow model was able to describe a lot of the differences in output and growth rates between the different countries in the sample. Incorporating human capital stock in the model increased the fit of the model with the data. Human capital stock may therefore be an important factor in economic growth.
An earlier model that incorporated the effect of human capital in a growth model, was designed by Hirofumi Uzawa (1965). He did not incorporate human capital in his model as a separate factor of production, but assumed that “various activities in the form of education, health, construction and maintenance of public goods … result in an improvement in labour efficiency” (Uzawa, 1965). He represented the state of technological knowledge in his model by the efficiency of labour and referred to this factor as the “educational sector”. He assumed that the impact of activities within this sector was uniformly distributed over the whole economy. With these propositions he was one of the first economists to include human capital in an economic growth model. In Uzawa’s model, an increase in human capital per worker causes an increase in the effective supply of labour. This increase will lead to an effect on the final output that is equal to the labour’s share of income, research has often estimated this to be around two-thirds of total income. This would mean that a one percent increase in human capital per worker will lead to a two-thirds of a percent increase of output. However, some economists have argued that the effect is greater due the fact that human capital can have increasing returns to scale (Uzawa, 1965).
A much debated issue in the studies of economic growth theories, is that of endogenous versus exogenous growth. Endogenous growth models go by the assumption that growth is influenced by parameters that can be influenced within the model itself. A model that assumes that investment in education improves efficiency and therefore contributes to economic growth, is endogenous because investment in education can be increased and decreased by men. A model that assumes that growth is determined by an external factor that cannot be changed or explained by the model is an exogenous model. An example of this kind of a model is the Solow model discussed above, in which economic growth settles at the exogenously determined rate of scientific progress. The debate whether an exogenous or endogenous model is a better explanation of economic reality, is still going on. The fact that human capital contributes some way or another to economic growth however, is generally accepted by economists.
2.1.2. Empirical Results
In 1991, Robert J. Barro analysed a cross-section of 98 countries from 1960 to 1985, using school enrolment rates as a proxy for human capital. He found that “the growth rate of real per capita GDP is positively related to initial human capital”. Together with Jong-Wha Lee, Barro composed a dataset which contains information on years of schooling from 1950 until 2010 for 146 countries. The countries considered in this dataset can be broadly divided into two groups: 122 developing and 24 advanced countries. With this data they performed several statistical tests to discover if there was a relationship between years of schooling and economic growth. They found that years of schooling has a significant and positive effect on economic output. They also estimated the rate of return to education, and found that it is within the range of 5 to 12%. (Barro, 2010)
Psacharopoulos and Patrinos summarize the different results of research concerning returns to investment in human capital. What they found is that the average rate of return to schooling for an additional year of schooling is ten percent. Another important result is that they find that the highest returns to education are found in low and middle income countries. This confirms the pattern earlier research has found, there are falling returns to education when economic development increases and the level of education increases (Psacharopoulus & Patrinos, 2002). In other words: returns to education are generally higher in developing countries than in highly developed countries.
Hanushek and Woessman also found proof of a positive effect of human capital on growth. Their results showed a statistically and economically significant relationship between cognitive skills and economic growth. They found that countries that had increasing cognitive skills levels over time, also experienced a relative increase in economic growth (Hanushek & Woessman, 2009).
2.2. THE RELATIONSHIP BETWEEN GOVERNMENT TYPE AND GROWTH
2.2.1. Theory
One of the key figures in 20th century economics is Nobel prize winner Milton Friedman. In his book “Capitalism and Freedom” (1962), he explains his vision on the relation between economic freedom and political freedom. He argues that politics and economics cannot be considered separate from each other. According to Friedman the way the economic system is arranged plays two key roles in promoting a free society. Economic freedom itself is a part of the broader concept freedom, thus economic freedom is a goal to strive for in itself. Secondly, economic freedom is vital for achieving the goal of political freedom because of the way economic arrangements affect the concentration or distribution of power.