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Human Capital, Public Policies, and Income Inequality Within and Across Countries

Final Report Summary - HUMAN CAPITAL (Human Capital, Public Policies, and Income Inequality Within and Across Countries)

The aim of this project is to develop a quantitative theory of human capital investment decisions –with quality and quantity of schooling- in order to quantitatively assess the importance of human capital in relation to total factor productivity (TFP) in accounting for the per capita income inequality observed across countries. A second objective of this project is to quantitatively investigate the effects of public policies on macroeconomic aggregates and the distribution of income. The results are summarized in three papers.

While economists consider human capital a crucial component of aggregate wealth, they have conflicting views on the importance of differences in human capital versus total factor productivity (TFP) in accounting for income differences across countries. In a first paper, we develop a quantitative theory of human capital investments to quantify the importance of differences in human capital versus TFP in explaining the variation in per-capita income across countries. We build a model of heterogeneous individuals -who make investments in schooling quantity and quality- and use a broad set of micro facts to discipline the key parameters of the human capital technology.

Our main finding is that human capital accumulation strongly amplifies TFP differences across countries: To explain a 20-fold difference in the output per worker the model requires a 5-fold difference in the TFP of the tradable sector, versus an 18-fold difference if human capital is fixed across countries. Two main channels explain why human capital provides substantial amplification. First, our calibration implies a large share of expenditures in the human capital production function, which means that a reduction in TFP affects disproportionately the benefits and costs of human capital accumulation. Hence, while the benefit of obtaining human capital is proportional to TFP, the cost of education (relative to the price of output) is less than proportional to TFP. This mechanism accounts for the low schooling quantity and quality in poor countries. Second, human capital is an important source of income differences across countries, not only because it directly contributes to cross-country output differences, but also because a lower human capital stock discourages physical capital accumulation.

There are substantial differences in labor supply late in the life cycle (age 50+) and in the design of tax and transfer programs across countries. In a second paper, we quantitatively assess the role of social security, disability insurance, and taxation for understanding differences in labor supply late in the life cycle (age 50+) across European countries and the United States. Our findings support the view that government policies can go a long way towards accounting for the low labor supply late in the life cycle in the European countries relatively to the United States, with social security rules accounting for the bulk of these effects. We find that social security rules account for the bulk of cross country differences in labor supply late in the life-cycle (in the order of 40 to 80 percent), but other policies also matter. In accounting for the low labor supply relative to the US at ages 60 to 64, taxes matter importantly in the Netherlands (6%), Italy (6%), and France (5%); disability insurance policies are important for the Netherlands (7%) and Spain (10%), and the low fraction of college individuals is a contributing factor in Italy (4%) and Spain (8%).

In a third paper, we develop a theory of capital market imperfections, entrepreneurship, and public policies. The goal is to improve our understanding of the low TFP and the high concentration of income and wealth in developing countries. We develop a quantitative theory of entrepreneurship, income inequality, and financial frictions disciplined with household level data from Brazil. The theory is used to quantitatively evaluate the impact of financial frictions on occupational decisions, resource allocation, aggregate output, and economic inequality. Conversely, we study how economic inequality shapes the impact of financial frictions in the economy. Our paper contributes to a seminal (mostly theoretical) literature that has emphasized the importance of the interaction between the distribution of wealth and financial frictions for the allocation of resources. Moreover, we use our theory of inequality to quantitatively assess the distribution of welfare gains and losses from eliminating financial frictions in the economy. The theory extends Lucas (1978) by modeling heterogeneity in two skills: -working and managerial skills. Consistently with the evidence, the theory implies three occupational categories: workers, employers, and self-employed entrepreneurs. We find that the removal of financial frictions decreases self-employment rates from 24% to 11% (with small effects on the number of employers), increases aggregate output by 48%, and has non-trivial effects on the distribution of income. We also find that while most households benefit from a reform that eliminates enforcement problems, the majority of employers (about two thirds) lose from the reform. By depressing the demand for labor, limited enforcement depresses the equilibrium wage rate, increasing the profits of employers. Our theory thus suggests that employers in Brazil may have a vested interested in maintaining a status quo with low enforcement.