The Rise in Returns to Education and the Decline in Household Savings

Abstract

This paper explores the consequences of rising returns to human capital investment on the personal savings rate. Over the past two decades, the return to college education has increased relative to high school education leading economists to argue the presence of 'skill biased technological progress'. The literature explaining household savings has also burgeoned considerably, motivated by its declining rate in the US over the past couple of decades. Stylized facts suggest a negative relationship between returns to education and savings rates across most of the past century and also a negative relationship between education spending and savings rates across OECD countries. In this paper, we present a model where a declining savings rate emerges as an outcome of an exogenously driven increase in the return to education. The link between the two is attributed to optimizing behavior of altruistic households. The results of our model are robust to the inclusion of life cycle savings and unintentional bequests. Some of the interesting results of our model are (i) a rise in the return to education raises education spending ratio by less than what it reduces the aggregate savings rate (ii) for some parameter values it actually reduces both the education spending rate and the aggregate savings rate and finally, (iii) it also raises the return to capital due to physical capital-human capital complementarity.