Abstract:We extend the standard human capital earnings function to include dispersion in the return to schooling by treating the return as a random coefficient. If the rapid expansion in participation in higher education has been brought about by dipping further into the ability distribution, we should observe a rise in the variance of returns. Alternatively, if the expansion has come about through relaxing credit constraints then we might expect to see an increase in both the mean and variance of returns. Our estimates suggest that the variance in returns has not risen over time.

We analyse how progressive taxation and education subsidies affect schooling decisions when the returns to education are stochastic. We use the theory of real options to solve the problem of education choice in a dynamic stochastic model. We show that education attainment will be an increasing function of the risk associated with education. Furthermore, this result holds regardless of the degree of risk aversion. We also show that progressive taxes will tend to increase education attainment.JEL Classification: J24, C61, D81.

We thank Tom Stoker, Josh Angrist, Jim Poterba, Colm Harmon, Ian Walker and seminar participants in UCD, Warwick University and the Centre of Economics of Education at LSE, for helpful comments. We also thank Yu Zhu for help with the data. All errors remain our own. The views expressed in this paper are those of the authors and not necessarily those of the National Bureau of Economic Research.