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The Study in Brief
The currently dominant view of universities is that Canadian governments neglect them. University students complain that tuition fees and student debt loads are increasing rapidly, government spending per student is lower now than some years ago, and so on. This focus in public debates on postsecondary spending has eclipsed the effect of tax measures on the incentive to invest in human capital.
Changes to the personal tax system have the potential to greatly influence the return students make on university studies, and we know that significant tax changes have taken place in recent years. Overall, when considering both spending measures and tax measures, is university enrolment being encouraged or is it not? And how has the incentive changed?
It is possible to answer these questions by deriving measures of the effective tax rate and the effective subsidy rate for university studies, and then subtracting one from the other to obtain net public encouragement to university enrolment.
These calculations show that the effective subsidy rate fell only slightly between 1998 and 2003, while the effective tax rate fell substantially more. Consequently, net encouragement to university studies increased from 5.8 percent to 10.8 percent in that period.
Two recent tax changes are responsible for most of the boost in the net incentive to study: The decrease in the progressivity of the tax schedule, which the federal government introduced in 2000, and the doubling of the amount of the education tax credit in 2003. Recognizing that the form of public encouragement of university participation has changed somewhat and increased in recent years should cast new light on current debates. If governments have already increased their support for universities and students, is there really a need for further increases in subsidies? We conclude that the answer is probably no.
There is, however, room for improvement in the design of the current subsidy package. What is needed is not more, but smarter, subsidies and tax breaks.
The Authors of This Issue
Kirk A. Collins is an Assistant Professor in the Administrative and Commercial Studies Program at the University of Western Ontario. He researches issues relating to human capital, taxation and political economy.
James B. Davies is a Professor in the Department of Economics at the University of Western Ontario. In addition to working on human capital and taxation he is currently researching the world distribution of wealth and edits Canadian Public Policy.
In recent years, investment in human capital has come to be viewed as vital for Canada's economic prosperity. Empirical evidence is mounting that human capital is linked to economic growth, and popular new economic theories suggest that it is a key element in innovation and technology adoption. It was with this growing recognition of the importance of both human capital and research that the federal government, in the late 1990s, adopted a growth strategy to promote what is known as the "knowledge-based economy." That strategy led Ottawa to introduce the Millennium Scholarship program, as well as a series of tax measures to encourage participation in higher education. It has also led to increased investment in research and graduate training at Canadian universities, as well as to greater interaction between academic researchers and the private sector.
Despite major initiatives at the federal level to encourage human capital investment, however, one often hears--from universities, students, and others-that Canadian governments are neglecting higher education. Tuition fees and student debt loads are increasing rapidly, while spending per student is failing to keep pace with levels that prevail at public universities in the United States. Yet enrollment at Canadian universities also continues to increase. What is going on? Is university enrollment being encouraged or is it not? How can one tell?
In this Commentary, we show that it is possible to answer these questions, at least in part, by updating past measurements of private and total rates of return to university education. They can be answered even more fully, however, by using some new tools that allow us to measure the assistance to education provided by both the expenditure and tax sides of the ledger.
Since the 1960s, Canadian researchers have repeatedly estimated the gap between the private rate of return to university education and the total rate of return from a public viewpoint. Our results show that, for the simplest income tax scenario (individuals with no dependents and no deductions), this gap stood at less than a single percentage point for first-degree university studies in 1998, a result that reflects only surprisingly mild encouragement of university study. In view of the large subsidies Canadian taxpayers provide both universities and students, why is the gap between total and private rates of return not wider?
We show that, in fact, the gap reflects the difference between what economists call the "effective subsidy rate" (ESR) and the "effective tax rate" (ETR) on this form of human capital investment. The key to understanding the mild net public encouragement of university study in 1998 is that, at the time, although the ESR stood at about 19 percent, the ETR was around 14 percent, which cancelled most of the boost subsidies gave to higher education. From 1998 to 2003, however, while the ESR rose slightly, to 21 percent, the ETR fell to about 10 percent, which significantly increased net public financial encouragement of university attendance.
Of the large number of tax changes that have affected human capital in recent years, two alone are responsible for most of the decline in the ETR between 1998 and 2003: the decrease in the progressivity of the tax schedule, which the federal government introduced in 2000, and the doubling of the amount of the education tax credit in 2003. Focus in public debates on expenditures on postsecondary education has eclipsed the human capital effects of these tax changes. It is important to redress that balance.
Recognizing that public encouragement of university participation has both changed form somewhat and increased in recent years should cast new light on current debates. If governments have already increased their support for universities and students, is there really a need for further increases in subsidies? We conclude that, in aggregate terms, the answer is probably no. There is, however, room for improvement in the design of the current subsidy package. What is needed is not more, but "smarter," subsidies and tax breaks.
Rates of Return to Education
Estimates of the total and private rates of return to university education in Canada typically take into account both the costs of obtaining that education and the gain in annual earnings the individual reaps from it throughout his or her working lifetime. If costs were in the form of a lump sum amount paid in a single period and earnings gains were constant from year to year, one could calculate the private rate of return simply by dividing the amount of the earnings gain by the amount of the costs. For the private rate of return, costs would be only those borne by the individual and the earnings gain would be measured after tax. In calculating the total rate of return, however, one would need to consider both the full costs of education, not just those borne by the individual, and the before-tax earnings gain.
Of course, the returns to education are not constant over a lifetime and costs are not incurred at a single point in time; rather, both are distributed over a number of years, which requires the use of what economists call "internal rates of return" to calculate the required rates of return to education. (1)
Emery (2004) catalogues 21 earlier studies that estimate total and/or private rates of return to education, either for Canada as a whole or for a particular province. Because they use different data sources and methods, these studies have produced a wide range of estimates, which makes it difficult to discern trends over time. Emery attacks this problem by summarizing the trends in estimates over time statistically. This approach, while unconventional, is nonetheless useful as it allows him to control for some of the major differences in methods and data sources. His results, shown in Table 1, give an idea of representative estimates for selected years from 1970 to 1998. They indicate that net rates of return rose gently from 1970 to 1990, then declined somewhat, while total rates of return initially declined, then increased. The gap between these two measurements peaked at 3.9 percentage points for males and 7.2 percentage points for females in 1980. By 1998, according to Emery's summary, the gap had declined to a mere 1.6 percentage points for males and 4.9 percentage points for females.
Although these patterns are interesting, we cannot tell from previous work how much of the decline in the gap between net and total rates of return since 1980 is due to falling subsidies and how much is the result of increased income tax burdens. This requires a decomposition of the subsidy and tax effects, to which we now turn for a comparison of the rates of return for 1998 and 2003.
Our Estimates of Rates of Return
It is impossible to calculate with certainty the rate of return to a university education for any single individual: even at the end of the person's working life and with full data on his or her education and earnings, the exercise would involve guesswork. The reason is that one would also need to know how much the individual would have earned without a university education, which could be estimated by looking at the earnings of otherwise similar people who did not go to university, but the results would obviously be subject to error. Moreover, even if it were possible to measure an individual's rate of return to education, the result would have only historical value. Instead, we want to know what social and individual rewards to education are implied by the present structure of education finance and how much today's graduates can expect to earn in the...
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