Sheepskin Effects in the Returns to Education

Abstract

Some previous discussions have dismissed screening theories of education partly on the ground that diploma years of education do not confer especially large earnings gains. Similarly, most empirical research on earnings functions has assumed an absence of effects. report evidence, however, of substantial and statistically significant sheepskin effects. Although this suggests that the previous dismissals of the screening hypothesis were premature, our evidence of sheepskin effects is amenable to nonscreening interpretations also. According to screening theories of education, individuals with more schooling tend to earn more not because (or, at least, not solely because) schooling makes them more productive, but rather because it credentiates them as more productive. A frequently cited article by Layard and Psacharopoulos (1974), however, dismissed the importance of the screening hypothesis on the grounds that several of its refutable predictions were not supported by available evidence. One of these was the prediction that wages will rise faster with extra years of education when the extra year also conveys a certificate. After surveying a number of studies, Layard and Psacharopoulous (henceforth LP) concluded that of return to dropouts are as high as to those who complete a course, which refutes the sheepskin version of the screening Since publication of the LP paper, an undergraduate labor economics textbook' has cited LP's analysis of sheepskin effects as telling criticism of the screening hypothesis. A prominent proponent of the screening hypothesis, Riley (1979), has accepted LP's summary of the empirical evidence, but responded that some versions of the screening hypothesis do not imply sheepskin effects. In the meantime, the ongoing flood of empirical research on earnings functions typically has continued to treat the natural logarithm of the wage rate as a linear (or occasionally quadratic) function of years of education, with no allowance for discontinuities in diploma years.2 The estimated rates of return used by LP were based on data that did not disaggregate dropouts' earnings by how many years of school they had LP acknowledged, We would have preferred to show the earnings gain associated with each year of the course, including the year when it was successfully completed. This note presents a reanalysis of sheepskin effects based on the type of data LP wished they had. The results contain very strong evidence of sheepskin effects after all. The next section describes our analysis, and the following section summarizes and discusses our