Abstract

Abstract: This paper represents an early attempt to analyze thecomprehensive relationship between public educational expenditure and structural change, which is often measured by labor transfer from agriculturalsector to industrial sector in developing economies. I construct a two-sectorgeneral equilibrium model, showing that: In the short term, public educational expenditure mainly acts as the role of crowding out industrial capital accumulationand thus temporarily hinders structural change, while there is an inverted-U relationshipbetween them in the long run, as public educational expenditure helps reduceeducational cost of rural residents permanently. China’s hukou system providesappropriate data to empirically identify this comprehensive relationship. Theempirical evidence, confirms the theoretical interpretations when I control forconfounding factors, take endogeneity of public educational expenditure intoaccount, and investigate the mechanisms behind the relationship. China’scurrent level of public educational expenditure is still far from its optimalvalue, as indicated by the inverted-U relationship with structural change,suggesting that China should increase spending on public education, especially forrural residents.

Keywords: Public EducationalExpenditure; Structural Change; Crowd-out Effect; Human Capital

There are two components of economic development: economic growth and structural change. At least since the work of Lucas (1988), human capital accumulation has been identified as a potential engine of growth. A natural question then comes to mind: is human capital accumulation also a potential engine of structural change? In fact, the story may be as simple as that of growth: human capital accumulation, which provides the basic labor skills for modern economic activity, facilitates rural residents’ transfer to the non-agricultural sector and promotes structural change. There is also considerable evidence to support a link between human capital accumulation and structural change, especially from the perspective of labor transfer. Examples include Sjaastad (1962), Shryock and Nam (1965), Greenwood (1969), Bowles (1970), Schultz (1982), Zhao (1999), and Lucas (2004).

To enhance human capital and thus promote structural change, the government must not only play the role in providing funds for schooling, but also must put more emphasis on rural educational expenditure, as in most developing countries, structural change takes place in the transition of workers from the agricultural sector to the industrial sector. Growth in the industrial sector requires large numbers of laborers, who mostly live in rural areas of origin where there is low labor productivity and thus, little money to pay for education.

However, public educational expenditure will not always promote structural change. The direct effect (the reduction of educational cost) can be diminished or even negated when other inputs to human capital accumulation are negatively affected by general equilibrium adjustments. If the reaction is severe enough, these equilibrium adjustments may dominate.  Such equilibrium adjustments may also explain the reason why governments in most developing countries fail to provide enough public educational expenditure, especially in rural areas. Even if the equilibrium adjustments do not dominate in the long run, the short-term effects are inevitable. Government officials who are faced with career pressures will choose to underprovide funds for education in order to stimulate short-term economic growth, but, the choice results in the stagnation of long-term sustainable economic development.

Therefore, a comprehensive analysis of public educational expenditure and structural change is needed, as this issue has largely been overlooked in development research, at least from an analytical perspective. This paper represents an early attempt to analyze the comprehensive relationship between public educational expenditure and structural change.  Numerous articles analyze the general equilibrium adjustments of public educational expenditure on growth and show that the impact is non-monotonic. For example, Brauninger and Vidal (2000) show that educational expenditure crowds out physical capital and lowers economic growth temporarily, while it maximizes the long-term growth rate. Similar research includes Devarajan et al. (1996), Sylwester (2000), Blankenau and Simpson (2004), and Blankenau et al. (2006). This research, although not directly related to public educational expenditure and structural change, provides some analytical foundations for this paper. There are other works that argue that public educational expenditure has an indirect growth effect by encouraging private investment. This theory is found in Zhang (1996), Milesi-Ferretti and Roubini (1998), and Hendricks (1999), for example.

This paper firstly develops a general equilibrium model of public educational expenditure and structural change. In the model, I show that there is a non-monotonic relationship between public educational expenditure and structural change. In the short term, public educational expenditure crowds out industrial capital accumulation, reduces the demand of non-agricultural sectors for rural laborers and thus temporarily hinders structural change. This is also why most governments under-provide public educational services. In the long run, even if public educational expenditure lowers the educational cost of rural residents, there is no reason to expect a positive linear relationship between public educational expenditure and structural change, and the relation between still depicts an inverted-U curve. Reasonable public educational expenditure can promote structural change. Otherwise, the crowd-out effect still dominates the reduction effect of educational cost.

China’s hukou system makes it possible to empirically identify the comprehensive relationship between public educational expenditure (see detailed description in Section 4) and structural change. The empirical evidence, when I control for confounding factors, take into account endogeneity of public educational expenditure, and investigate the mechanisms behind the relation, confirms the theoretical interpretations. It is noteworthy that the findings of this paper do not diminish the relevance of structural change and public educational expenditure, but rather point to the importance of recognizing the complex and possibly non-monotonic nature of the expenditure-structure relationship. Furthermore, this analysis highlights the importance of considering appropriate policies that can help turn government educational expenditure into a more efficient engine of sustainable economic development.

The current research is especially relevant in the context of current China. Hukou system[1] in China still hinders rural-to-urban migration in China by discriminating against migrants in terms of educational, medical, and other welfare assistance. Therefore, public educational expenditure on rural residents serves as an important way to reduce the negative effect of hukou system on structural change and rural-to-urban migration. Rural residents, due to their identities, stay in rural areas at least in their juniors and cannot enjoy high-quality education due to urban-rural educational disparity, which further prevents them from migrating to cities and get qualified jobs. Therefore, if one’s rural hukou status cannot be altered due to administrative difficulties, one possible and very important way to alleviate the effect of hukou system on structural change is to increase educational expenditure and improve the educational quality on rural residents, so that rural residents can overcome human capital disadvantage and migrate to city to work. In fact, if the government itself wishes to remove hukou system, what it can do is also to remove the discrimination on educational, medical, and other welfare assistance. Therefore, if any discrimination on educational, medical, and other welfare assistance is mitigated, the hurdle from hukou system is also reduced, especially in the context that China’s level public educational expenditure is still far from its optimal value, suggesting that China should increase spending on public education, especially for rural residents.

The rest of the paper proceeds as follows. Section 2 develops a general equilibrium model of structural change with two sectors and discusses the short-term and long-term effect of public educational expenditure on structural change, as well as human capital. Section 3 provides the empirical specifications. In Section 4, I introduce the data for empirical analysis. Section 5 and 6 provide empirical results as well as robustness checks. Section 7 concludes.

[1] Hukou is a household registration system that was introduced in 1958 to control rural-to-urban migration in China. At that time, a Chinese citizen was given a rural or urban hukou. Newborn children inherit their hukou status from their mothers. The urban hukou is associated with certain privileges and entitlements (social security and public services) that the rural citizens cannot enjoy, even today. It has been very difficult to alter one’s hukou status. Before the early 1990s, rural citizens could not migrate to cities and towns. More recently, migration has been allowed, but the hukou system still discriminates against migrants in terms of educational, medical, and other welfare assistance.