A Critical Evaluation of Rate of Return Analysis
Since the development of the concept of human capital (Schultz, I 96 I; Becker, I964), analysis of rates of return has been a standard means of assessing education. The conventional way of measuring the return to education is to take a snap-shot view of the earnings of people with differing educational experiences. It is then possible to calculate the average income earned at different stages of a working life. The rate of return to education can then be calculated as the internal discount rate which equates the discounted increment to average earnings to the costs involved in obtaining education. Both private and social rates of return can be calculated. Provision of education is often subsidised, so that the private cost is lower than the social cost and this will tend to raise the private return above the social return. Taxation of the private benefit of education offsets this at least partly. However, Ziderman (I 973) records that, in developed countries, private returns normally exceed social returns; this pattern is confirmed by Psacharopoulos (I985). In many cases it is not possible to calculate a full rate of return, but one can look at the incremental effect of schooling on earning power. Thus Denison (i 967) suggests that, in the United States, each year of education raises earning power by an average of around 5-6 % with the effect tending to rise with the duration of education. Card and Kruger (I992) identify effects of similar magnitude. It need not be the case that education goes on raising earning power. Overeducation is clearly possible. Rudd (I990) suggests that, in the social sciences, education beyond degree level is very damaging to earnings prospects. Tarsh (I992) questions aspects of Rudd's study,' but agrees that 'higher education graduates do suffer some pay disadvantage'. Rate of return calculations can form the basis for policy decisions. In principle social returns to investment in human capital could be compared with those on physical capital so as to give a, basis for the allocation of resources between the two types of investment. Estimates of social rates of return to different types of education could also be used to guide expenditure decisions between these different types. However there are many, possibly offsetting, biases entering into the calculations of rates of return and it is perhaps concern with these that has