Education Budgeting: Public return on education should be the point of reference

OGURO Kazumasa
Consulting Fellow, RIETI

"Education is the most powerful weapon which you can use to change the world," said Nelson Mandela, who fought to abolish apartheid and became the first black president of South Africa. In other words, education is to invest in the next generation upon which the future of our country rests. Indeed, it is the foremost important policy in planning for the next 100 years of the nation. However, faced with severe fiscal constraints, the Japanese government is inclined to cut down on budgets for policy implementation in education and many other areas except for social security. How to secure financial resources for education is now posing a huge challenge to Japan.

Against this backdrop, politicians are seriously studying—albeit against all odds—the possibility of introducing some new schemes to secure funds for education, such as an education bond program and a children's education insurance program. The education bond program is to issue a new type of national government bond specifically designed to finance university and other higher education, while the children's education insurance program aims to offer free preschool education and childcare by securing funds in the form of additional social security premiums.

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In considering the viability of these programs, it is necessary to measure the effects of proposed measures from the viewpoint of cost-benefit analysis, which compares the cost and benefit expected to be incurred over a given period of time. In the context of education budgeting, the return on education is a key performance measurement.

The return on education is calculated in the same way as the return on investment (ROI), regarding education as investment. Conceptually, there are two ways of defining it, namely, the private return on education and the public return on education. The private return on education is calculated from private benefits (e.g., incremental increase in lifetime earnings resulting from receiving university education) and private costs (e.g., expenses incurred by individuals for university education), and the public return on education from total benefits including social benefits (e.g., increase in tax revenue due to greater income earned by those with higher education, and reduced unemployment) and total costs including social costs (e.g., subsidies and scholarships).

According to the Organisation for Economic Co-operation and Development (OECD)'s report on education published in 2016 (see Table), Japan fell below the OECD average in the return on higher education for both men and women. This reflects the fact that wage gaps between college-educated workers and those with only high school education in Japan are not as large as that in the United States and Europe. On the other hand, Japan significantly exceeded the OECD average in the public return on higher education due partly to a relatively low level of public support to education.

Table: Return on Higher Education in Major Countries (% per annum)
Public return Private return
Men Women Men Women
Hungary 22 13 24 14
Japan 21 28 8 3
Czech Republic 16 12 22 15
Chile 16 13 15 12
United States 12 8 15 12
Israel 12 7 14 13
Australia 10 10 9 9
OECD average 10 8 14 12
Italy 9 6 9 8
Netherlands 8 7 8 7
Canada 6 6 9 12
Spain 6 5 10 11
Norway 5 3 9 9
New Zealand 5 4 7 7
Source: OECD

Education bonds are, so to speak, an education loan extended to—and to be repaid in the future by—the entire generation of children. Theoretically, bonds are justifiable when the public return on this scheme exceeds the market interest rate on such bonds, insofar as proceeds from education bonds are not diverted to other purposes such as bailing out universities suffering from a lack of students.

In reality, however, the Japanese government is in a chronic state of deficit, with tax revenue falling far short of current expenditures, including education budgets. In a sense, part of deficit-covering bonds, in substance, are already operating as education bonds. Allowing additional issuance of government bonds in the name of education amid such a dire fiscal situation would increase the risk of fiscal failure.

What the government should be looking at is not the possibility of increasing the total amount of bond issues. If anything, it should be pondering how to better allocate the proceeds of the so-called "construction bonds," a type of Japanese government bond issued to finance public works projects such as infrastructure construction, which have long been subject to vested interests.

Public investment by definition refers to a broad range of investment, not limited to investment in public infrastructure such as highways and dams, but including investment in human capital formation, e.g., through education and investment in science and technology. Despite this, the government may issue public works financing bonds only for the purpose of infrastructure development as per the relevant provision of the Public Finance Act. However, now that Japan's infrastructure is well developed and its population is set to decline, we cannot continue to single out infrastructure investment as a priority.

In the process of transition from a labor-intensive economy to a capital-intensive economy following World War II, infrastructure development played a significant role in Japan's postwar reconstruction and subsequent high economic growth. In today's world, however, the fourth industrial revolution, exemplified by the evolution of artificial intelligence (AI) and big data, is underway and many countries, including Japan, are now shifting to an information-intensive economy. In the years to come, improving the quality of human capital as a source of new knowledge, rather than expanding physical capital, will be what counts the most.

Furthermore, new knowledge and ideas generated by human capital have the attributes of public goods. Infrastructure investment financed by construction bonds and public investment in human capital financed by education bonds are no different in that they are both investment in capital. Rather than treating construction bonds as a sacred cow, the government should set a limit on the issuance of government bonds for public investment in general in a way consistent with its goal of achieving fiscal reconstruction. It is within this framework that the government should examine each public investment project, by using cost and benefit analysis or else, to determine whether to go ahead with it.

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What about the children's education insurance program? The program is to insure the risk of children not being able to receive necessary nursing care, education, etc. The greatest criticism is that the program, in substance, is not a social insurance program but a scheme to raise income taxes in the name of a new social insurance program. According to the proposed plan, the beneficiaries of the program are limited to those in a specific age group who will likely have children in the coming years. The risk covered by the program does not exist for those who have already passed that stage of life. In this context, it is unreasonable to define the proposed scheme as a social insurance program.

However, the proposed program may be theoretically justifiable when put in another light. The greatest challenge facing the Japanese economy today is a declining population. Meanwhile, the current public pension program is a pay-as-you-go system, in which pension benefits paid to elderly people are financed by funds collected from the working generation. Under this system, those who have never raised children are entitled to receive pension benefits without having to bear the cost of raising children during their working age. This means that they are free riding since the source of finance for pension benefits are funds collected from those raised by someone else. Consequently, this operates to accelerate the decline in the number of children.

Just as education has a positive externality on economic growth, a pay-as-you-go pension program has a negative externality on fertility. A theoretical study by Dr. Bas van Groezen of Tilburg University and others showed that there are two policy options to address this negative externality. One is to raise fertility by providing greater tuition subsidies and child allowances. The other is to offer additional old age pension benefits to those who have raised children.

The proposed children's education insurance program can be regarded as part of the public pension program and premiums paid into the program as the payment of additional pension benefits in advance. One of the factors causing confusion is the name of the program, Kodomo Hoken, which literally translates as "Children Insurance." Renaming it, for instance, to "Children's Fund" and incorporating it into the public pension program would be a degree of theoretical consistency.

The only remaining problem is intergenerational burden sharing. Under the proposed plan, those in the working generation are to bear the financial burden in the form of premiums. The plan also suggest the possibility of asking retirees to bear their share of burden in the form of reduced benefits under the health and long-term care insurance programs. However, how this will work out remains unclear at the moment as the plan falls short of presenting any specific measures for reforming the health and long-term care programs as presented. From the viewpoint of ensuring intergenerational equality, the cost of rearing children including the cost of their education should be borne by all generations and thus financed by consumption tax revenue.

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Japan's public finance is debt outstanding, which already exceeds 200% of gross domestic product (GDP), and is continuing to rise. As such, Japan is not fiscally sustainable. In the near future, when it becomes imperative that Japan take drastic measures, including debt restructuring, to reconstruct public finance, which of the national policy areas—including social security such as the public pension and health insurance programs, infrastructure development, and education—should be prioritized in protection from budget cuts? We had better start thinking about this question now to develop a guiding philosophy. Apart from public health, education should probably be the top priority.

As Amartya Sen, a recipient of the Nobel Prize in Economics, points out, improvements in education—along with those in public health—proceed economic development and constitute a part of the institutional foundation that enables people to give full play to their potential and to develop human dignity. In Japan, which is scarce in natural resources, human resources are its greatest and most important resource. Education is the source of growth. For disadvantaged children, it is the key to overcoming difficulties to cut the chain of poverty. The crystal of knowledge accumulated by humans is a true asset that can passed onto the next generation.

The question of how to finance budgets for education is urging us to contemplate deeply on how to secure and allocate financial resources for investment in future generations and how to protect true assets.

>> Original text in Japanese

* Translated by RIETI.

May 29, 2017 Nihon Keizai Shimbun

June 21, 2017