Investing in Human Capital: Policy Priorities for Canada

1. Investing in Human Capital: Policy Priorities for Canada W. Craig Riddell Department of Economics University of British Columbia IRPP Canadian Priorities Agenda Conference Toronto March 8-9 2007

2. Meaning of human capital • Human capital refers to the skills, competencies and knowledge possessed by individuals • These skills and competencies include both cognitive skills such as literacy and numeracy and non-cognitive skills such as the ability to get along with others

3. Influences on human capital • Human capital is the outcome of many influences, both hereditary and environmental. • Three important influences are (i) the nurturing, nutrition and stimuli received in the early years of life (ii) formal education (iii) work experience and adult education and training • Particular attention will be paid to factors that can be influenced by public policy

4. Why human capital matters • Contribution to individual well-being • Formal schooling is one of the best predictors of “who gets ahead” • Better-educated workers earn higher wages, have greater earnings growth over their lifetimes, experience less unemployment, and work longer • Higher education is also associated with longer life expectancy and better health • Growing evidence that these links are causal in nature • Acquiring new skills also has some consumption value

5. Why human capital matters (cont’d) • Non-market and social benefits These includes: • increased civic participation • reduced participation in criminal activities • higher rates of innovation and economic growth • inter-generational effects: improved child health, education and well-being

6. Why human capital matters (cont’d) • Emergence of knowledge society and growing demand for skills • Technological change and globalization have led to growing demand for highly skilled workers and changes in the nature of skills needed in the workplace • These forces also appear to have contributed to widening inequality between more- and less-skilled workers in employment and wages • Growing concern about future skills shortages

7. Why human capital matters (cont’d) • Emergence of knowledge society and growing demand for skills(cont’d) • 'New growth theory' emphasizes the importance of human capital in the creation of new knowledge and in the growth of living standards over time • In social policy, greater emphasis on individual responsibility and on providing a “hand up” rather than “hand out” – “good skills are an essential part of the social safety net"

8. Why human capital matters (cont’d) • Distributional consequences and equality of opportunity • Human capital formation may ameliorate pressures for widening inequality by increasing the supply of more skilled workers and reducing the supply of the less skilled • Education is also often regarded as a mechanism for promoting equality of opportunity and social mobility

9. Key features of human capital decisions • These are principally investment decisions: individuals incur costs in the present in return for benefits in the future • Benefits of human capital acquisition typically accrue over a long period – e.g. higher earnings stream and improved health over many years • Individuals making such decisions need to compare the present value of the gradual accumulation of future benefits to the current costs • In order to make good decisions, individuals need to be “far sighted” rather than myopic

10. Key features of human capital decisions (cont’d) • Indeed, benefits of human capital investments are transferred across generations • A major component of the costs of acquiring human capital is typically the opportunity cost -- the income foregone by not working • The more skills an individual acquires, the higher the opportunity cost • Evidence indicates that “skill begets skill” – those with a good base of skills can more readily acquire additional skills

11. Key features of human capital decisions (cont’d) • Each of these factors implies that the return on human capital investments will be larger if the investments are made early in the life cycle rather than later • Because the benefits accrue in the future human capital investments are generally risky investments

12. Is government involvement in human capital formation warranted? • Government involvement in the provision and financing of education is widespread • This involvement may be justified on both efficiency and equity grounds

13. Is government involvement in human capital formation warranted?(cont’d) • The efficiency rationales involve potential "market failures" • Social benefits from education in excess of private benefits: such "external benefits" may result in under-investment in education in the absence of government intervention • Liquidity constraints: credit market failures that inhibit individuals from making productive investments. This may argue for government involvement in the financing of education

14. Is government involvement in human capital formation warranted?(cont’d) • The efficiency rationales involve potential "market failures"(cont’d) • Risks associated with human capital investments are generally non-diversifiable • Market for education suffers from pervasive problems of incomplete information. Government intervention could enable individuals to make more informed decisions. Public involvement in developing, publicizing and enforcing standards may be beneficial

15. Is government involvement in human capital formation warranted?(cont’d) • The efficiency rationales involve potential "market failures"(cont’d) • “Samaritan’s dilemma” -- even altruistic parents may not take into account the consequences of their child-rearing decisions on those outside of the immediate family • Another rationale for government intervention is based on the view that youths may make poor or myopic decisions, choices that imply social as well as private costs

16. Is government involvement in human capital formation warranted?(cont’d) • Equity reasons: promotion of equal opportunity and social mobility • Increased skill formation may ameliorate pressures for widening inequality in economic and social outcomes

17. Evidence on rates of return to human capital investments • Private returns associated with higher earnings • Many researchers have produced estimates of the “economic return” to schooling using conventional multivariate methods • Canadian studies using conventional methods obtain estimated real rates of return of approximately 8-10 percent • Such estimates compare favourably with rates of return on physical capital investments

18. Evidence on rates of return to human capital investments (cont’d) • Private returns associated with higher earnings (cont’d) • However, these estimates do not control for unobserved factors such as ability and perseverance that may influence both educational attainment and labour market success • Such unobserved factors are likely to imply that conventional estimates of the return to schooling are biased upwards • Important advances have recently taken place in our understanding of the relationship between education and labour market success

19. Evidence on rates of return to human capital investments (cont’d) • Private returns associated with higher earnings (cont’d) • These advances have occurred from the use of natural experiments that employ variations in educational attainment brought about by policy changes or unique events • Such variations allow one to identify the causal impact of education • A large number of such studies have now been carried out in numerous countries

20. Evidence on rates of return to human capital investments (cont’d) • Private returns associated with higher earnings (cont’d) • Several recent Canadian studies employ this “natural experiment” approach • Lemieux and Card (2001) study the impact of the Veterans Rehabilitation Act—the Canadian “G.I. Bill”. They estimate the rate of return to schooling to be 14 to 16 percent

21. Evidence on rates of return to human capital investments (cont’d) • Private returns associated with higher earnings (cont’d) • Compelling evidence comes from research on the effects of changes in compulsory schooling laws in Canadian provinces over the past century. Oreopoulos estimates rates of return in the 12 to 15 percent range from the additional secondary level schooling brought about by the changes in these laws • This recent research concludes that for certain groups the returns to additional education are particularly high –greater than conventional estimates that are believed to be biased upwards • Similar pattern of results found in many other countries

22. Evidence on rates of return to human capital investments (cont’d) • Private returns associated with higher earnings (cont’d) • Policy interventions that raised educational attainment -- typically affecting groups with relatively low levels of education -- had large beneficial effects on the lifetime earnings of these individuals • Returns to past incremental investments in education often exceeded the average return for the population as a whole • Results suggest that investments at the margin in education need not yield below-average returns, as would be the case if there were diminishing returns to all human capital investments

23. Evidence on rates of return to human capital investments (cont’d) • Non-market and social returns • Important advances have also taken place in understanding non-market and social consequences of education • Many studies find that educational attainment is correlated with numerous individual and social outcomes such as improved health, greater civic participation and reduced participation in crime • However, do these correlations reflect a causal impact of education on these outcomes? • Recent research using natural experiments has strengthened the case for believing that the non-market and social benefits of education are substantial

24. Evidence on rates of return to human capital investments (cont’d) • Non-market and social returns (cont’d) • Summarizing this evidence yields the following approximate estimates of the non-market and social returns to schooling:

25. Evidence on rates of return to human capital investments (cont’d) • Non-market and social returns (cont’d) • Non-market benefits include the social benefits associated with reduced crime, increased civic participation, improved health and longevity and inter-generational effects • Some of the intergenerational effects and the impacts of education on health are private in nature, but in both cases there is a social benefit in addition to the private benefit

26. Evidence on rates of return to human capital investments (cont’d) • Non-market and social returns (cont’d) • The estimated (real) social return of 6-9 percent is arguably a conservative estimate • However, there is more uncertainty about the magnitudes of the non-market and social benefits of schooling than is the case for earnings

27. Current state of human capital investment in Canada • Canada invests a substantial amount in formal education • Canada among the top G-7 and OECD countries in terms of expenditure per student at the elementary/secondary and post-secondary levels • Canada is about average among the OECD and G7 in terms of the fraction of GDP devoted to formal education

28. Current state of human capital investment in Canada (cont’d) • Although traditionally high by international standards, over the past decade Canadian expenditure on education has declined relative to most other OECD countries • For example, educational expenditure as a percentage of GDP has dropped from 25% above the OECD average in 1995 to equal to the OECD average in 2003

29. Current state of human capital investment in Canada (cont’d) • One consequence of this substantial expenditure is a population that is well educated by international standards • Compared to the U.S., Canada has lower educational attainment at both the bottom and top of the education distribution. Where Canada stands out is in the middle of the distribution

30. Current state of human capital investment in Canada (cont’d) • A unique feature of Canada’s education system is the substantial investment in non-university post-secondary education. The proportion of Canada's population with a college/trades diploma is much higher than that of any other OECD country • Another noteworthy feature is the limited public expenditure in the “early years” – prior to the beginning of formal schooling at age six

31. Current state of human capital investment in Canada (cont’d) • Although the overall educational attainment of Canadians is impressive, high school completion has been a weak spot for many years. Canada’s secondary school graduation rate is near the bottom of the G-7 and well below the OECD average • Although the high school drop out rate has been a declining over time, the level remains a source of concern • The high school drop out rate is much higher among males (29%) than among females (20%) and is especially high in rural areas and among Aboriginal students

32. Current state of human capital investment in Canada (cont’d) • Important advances have occurred in the provision of information on student achievement, a situation that contrasts sharply with that of 20 years ago • Students, parents, teachers, school administrators and policy makers now have access to a great deal more information about educational outcomes than in the past, and can base their decisions on a much improved information base

33. Current state of human capital investment in Canada (cont’d) • Recent international data on Canadian student achievement paint a mixed picture. Results from TIMSS, curriculum-based tests of achievement in mathematics and science, indicate that Canadian student achievement is satisfactory but not as good as one might expect given Canada's expenditure on elementary and secondary schooling • In contrast, 15-year-old Canadian students performed very well in the PISA tests that assessed the ability to apply knowledge in reading, mathematics and science

34. Current state of human capital investment in Canada (cont’d) • In reading, Canadian students were the top performers in the G-7, while in mathematics and science Canada ranked among the top three G-7 countries • The PISA results suggest that Canada appears to obtain reasonably good "value for money" from the elementary and secondary school system, at least as measured by average student achievement in reading, mathematics and science

35. Current state of human capital investment in Canada (cont’d) • There are substantial variations in student achievement across Canadian provinces. Some provinces—such as Alberta and B.C.—are able to obtain very high levels of achievement. In the Atlantic provinces, student achievement is relatively low by international standards • Data on student achievement provide some information on the skills of those who will be entering the labour force in the future. The International Adult Literacy Survey (IALS) provides measures of the skills of the adult population that are comparable across countries and language groups

36. Current state of human capital investment in Canada (cont’d) • The literacy and numeracy skills of Canada’s adult population are above average among the G-7 countries that participated in IALS • Canada, like the U.S. and U.K., has a high variance across the population in its literacy skills compared to European countries such as Germany • However, the 1994 IALS and the 2003 IALSS find that a disturbingly large fraction of the Canadian population has low levels of literacy and numeracy

37. Current state of human capital investment in Canada (cont’d) • By international standards, older and less well-educated Canadians have relatively poor literacy skills, whereas younger and well-educated Canadians have relatively good literacy skills compared to their counterparts in other G-7 countries • Immigrants and aboriginals also have low literacy and numeracy skills, controlling for education and age

38. Implications for policy • One distinguishing feature of existing policy is substantial public and private investment in elementary, secondary and post-secondary education • The empirical evidence indicates that, on average, the return to these investments is high • Furthermore, there is evidence of substantial social benefits

39. Implications for policy(cont’d) • However, high average returns to existing expenditures do not imply that additional public investments are warranted. What matters is the return at the margin • The return at the margin is likely to be highest in areas in which we currently devote relatively limited public resources to skill formation • In addition, the rate of return to marginal investments is also more likely to be high for investments made early in the life cycle

40. Implications for policy(cont’d) • A second distinguishing feature of the Canadian situation is that there are some important gaps in the skills of particular groups • Looking at the population as a whole, the resources devoted to human capital formation and the associated outcomes are reasonably good • However, despite satisfactory average performance, some groups have skill levels that are inadequate and present a serious barrier to maintaining a decent standard of living and to being able to fully participate in society

41. Implications for policy(cont’d) • These policy challenges could be addressed by increasing the public resources devoted to human capital formation in three specific areas • These areas are promising for two reasons. First, the rate of return at the margin to additional investments is likely to be high. Second, all three interventions would address important gaps that result in low skills among some groups or in unequal opportunity

42. Policy proposals Early childhood education (ECE) intervention Rationale: • Many children start school with significant academic disadvantages • Many social and emotional problems are evident prior to school entry • Evidence suggests it is important for children to get off on the right foot in school

43. Early childhood education (ECE) intervention (cont’d) Rationale (cont’d): • Many skills are best learned early in life • “Skill begets skill” – those with a good skill base are more able to acquire additional skills • Early interventions result in a long period over which benefits can accrue

44. Early childhood education (ECE) intervention (cont’d) Rationale (cont’d): • Difficult to fix problems later – e.g. employment programs focused on those experiencing labour market difficulties have been found to be relatively ineffective • Improved school readiness may improve outcomes of K-12 by reducing the variability of skills at school entry age

45. Early childhood education (ECE) intervention (cont’d) Rationale (cont’d): • Limited public investment suggests that potential returns from investments at the margin may be high • However, it is important to take into account the existing private investment

46. Early childhood education (ECE) intervention (cont’d) Rationale (cont’d): • Over 50% of Canadian pre-school age children are enrolled in some form of child care, and some of these programs have a significant educational component • In addition, parents and community organizations invest substantial time and money in enhancing the skills and competencies of children • ECE programs targeted on those who would not otherwise get a good start may be very beneficial for participants and for society

47. Early childhood education (ECE) intervention (cont’d) Evidence supporting this choice of policy: • Considerable U.S. experience with ECE programs that aim to improve the skills of disadvantaged children • Evidence is available on: (i) small scale model programs focused on specific target populations and (ii) publicly funded large scale programs such as Head Start • Both types of interventions are restricted to children from disadvantaged backgrounds

48. Early childhood education (ECE) intervention (cont’d) Evidence supporting this choice of policy (cont’d): • The most convincing evidence comes from small scale demonstration projects with randomized research designs • Evidence from studies of model programs with randomized assignment indicates that ECE programs targeted on disadvantaged families can have long-lasting and large beneficial effects • Most such interventions do not have long term effects on IQ

49. Early childhood education (ECE) intervention (cont’d) Evidence supporting this choice of policy (cont’d): • However model ECE projects find evidence of increased student achievement, decreased grade retention, less utilization of special education, less crime and delinquency and higher probability of completing high school

50. Early childhood education (ECE) intervention (cont’d) Evidence supporting this choice of policy (cont’d): • Compelling evidence comes from: • Perry Preschool program, a half-day educational program for children aged 3 to 4 during the academic year plus teacher home visits with parents • This program, which has now followed participants to age 40, had significant impacts on adult income, the probability of owning a home, welfare receipt, and number of arrests