EDUCATION AND ECONOMIC GROWTH
IN SLOVENIA
A DYNAMIC GENERAL EQUILIBRIUM APPROACH
WITH ENDOGENOUS GROWTH





Miroslav Verbi
Boris Majcen
Mitja Čok



















WORKING PAPER No. 45

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EDUCATION AND ECONOMIC GROWTH
IN SLOVENIA:
A DYNAMIC GENERAL EQUILIBRIUM APPROACH
WITH ENDOGENOUS GROWTH

Miroslav Verbič1
Boris Majcen2
Mitja Čok3


WORKING PAPER No. 45 - 2009



Editor of the WP series: Boris Majcen

© 2009
Institute for Economic Research




Ljubljana, October 2009


1 Faculty of Economics, University of Ljubljana, Slovenia & Institute for Economic Research, Ljubljana, Slovenia
2 Institute for Economic Research, Ljubljana, Slovenia
3 Faculty of Economics, University of Ljubljana, Slovenia

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CIP - Kataložni zapis o publikaciji
Narodna in univerzitetna knjižnica, Ljubljana

37:330.34(497.4)

VERBIČ, Miroslav
Education and economic growth in Slovenia : a dynamic general
equilibrium approach with endogenous growth / Miroslav Verbič,
Boris Majcen, Mitja Čok. - Ljubljana : Institute for Economic
Research, 2009. - (Working paper / Inštitut za ekonomska
raziskovanja, ISSN 1581-8063 ; no. 45, 2009)

ISBN 978-961-6543-71-2

1. Majcen, Boris 2. Čok, Mitja

248036352

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Abstract



In the article we model education and human capital as major endogenous growth elements in a
small open economy general equilibrium framework and consider several policy scenarios for
Slovenia. Decrease of the PIT rate and increase of government spending on education turned
out to be the most effective policy measures. It is important, though, to understand its transitory
dynamic. Namely, as education expenditure is increased, certain amount of labour is
temporarily withdrawn from its productive use and put into the educational system. Higher skill
upgrade of labour requires longer and higher short-term labour force decrease, but also
provides us with higher long-term growth. The households that would gain more utility from
such policy scenarios are those with more skilled labour and thus higher income level.


JEL classification: C68, D58, E24, H52.


Keywords: education, endogenous growth, general equilibrium modelling, Slovenia.

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1.
Introduction


The topic of economic growth is among the most essential issues in macroeconomics, as
it directly affects the living standard of the population and the welfare level. As a result, the
search for fundamental determinants behind the growth process is an ongoing research theme.
There are broadly speaking two dominant theories; the neoclassical growth approach and the
endogenous growth approach (cf. Barro and Sala-i-Martin, 2003). Neoclassical growth
models assume that productivity growth is exogenous. This view has changed in the early
1980s. According to the new growth theory, the long-run economic growth is affected by
deliberate economic behaviour and human actions.

Economists agree that the long-run growth potential in per capita growth is determined
by advances in productivity. Production can to certain extent be expanded extensively through
investment in factor inputs and through employment growth, but in the long run intensive
improvements in productivity are required. By working in a more efficient way, more can be
produced with given factor inputs. The major determinants of the productivity growth are
investments in education and thus human capital, and in research and development (R&D).
Along these lines, the theory of economic growth turned into the theory of productivity
growth.

While these ideas have been tested in a number of empirical studies, they are struggling
to find their way into general equilibrium modelling, which has led to a good deal of
criticism. As Ghiglino (2002) pointed out, endogenous growth theory has had some success in
explaining the observed data related to the process of economic growth, but the results of the
models are typically very sensitive to their microeconomic structure. Therefore, valuable
insights can be gained by integrating endogenous growth theory into the framework of
general equilibrium theory. The motivation behind our work is to construct and develop a
dynamic general equilibrium model with endogenous growth, driven by investment in
education and R&D, which will enable us to analyze the impact of these determinants on
economic growth in the context of complex mutual activity of economic agents that is taking
place in their socio-economic environment. Our contribution to the existing model literature is
a focus on a small open economy case of Slovenia, where a large part of the technological
change comes from abroad. In this article, we focus on integrating education and human
capital as major endogenous growth elements into an inter-temporal general equilibrium
framework for Slovenia.

Human capital can be introduced as an additional factor in production primarily
contributing either to equilibrium in production levels in a neo-classical growth framework or
– as is the case in the present article – to a balanced growth rate in an endogenous growth
framework. It can also play a productive role in terms of the absorption capacity to assimilate
new technologies. Growth figures indicate that an increase in the average education level of
the population by a single year increases the long run per capita output by 6-8 per cent
(Dowrick, 2003; Canton et al., 2005; Canton, 2007). If education is subject to decreasing
returns to scale, the impact on per capita output might be smaller in countries with high

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education levels. However, these relationships should also be dependent on the quality of
institutions and its regulation (cf. Klun and Slabe-Erker, 2009). Nonetheless, while increases
in human capital, R&D, and product market competition can improve macroeconomic
performance, it takes time before these benefits are realised.

From another perspective, educational attainment is also regarded as one of the key
factors influencing the distribution of income across both households and labour categories
(cf. Yeldan and Voyvoda, 2000). On the one hand, educational attainment and individual’s
stock of human capital formation enable its owner to obtain better-paying jobs, more
bargaining power and flexibility in the job market. On the other hand, initial distribution of
wealth and household income have direct impacts on the family’s capacity to invest in its
offspring’s human capital formation, as most of the investments in education are made when
agents are young. Under these conditions, provision of public funds to education and the
government’s ability to invest in education and human capital formation play a crucial role in
both attaining greater equality and in promoting growth. Such observations bring issues of
human capital formation and optimal design of public policies in terms of investment in
education, fiscal debt management and the inter-household and inter-generational burden of
taxation into forefront of analysis.

The outline of the article is as follows. In Chapter 2 a current literature overview on
education-driven endogenous growth models is presented. In Chapter 3 a broad description of
the general equilibrium model of the Slovenian economy is provided, while in Chapter 4 we
show in detail how education and human capital are modelled in a dynamic general
equilibrium framework. In Chapter 5 the scenarios are described and the results of simulations
are presented, where we focus in particular on macroeconomic and welfare aspects. In the
final chapter we summarize the main findings of the article.



2.
Literature Overview on Education-driven Endogenous Growth Models

The endogenous growth literature captures the insight that the crucial force behind
positive growth rates is the elimination of the tendency of diminishing returns to investment
in a broad class of capital goods, including human capital. Antecedents of this literature
utilize theories of technological progress, innovation and imitation (Romer, 1987; Grossman
and Helpman, 1991), learning by doing (Stokey, 1991), and population change, fertility and
human capital investment (Becker and Barro, 1988) in order to introduce increasing or
constant returns to scale to the cumulative factor of production. Recent advances in the new
growth theory identify, among many others, the degree of educational attainment as a crucial
determinant of the long-run rate of economic growth (cf. Gallipoli et al., 2006; Canton, 2007).

Following the lines of Uzawa (1965) and Lucas (1988), many theories have been
developed to explain the process of human capital accumulation via investment in education,
both public and private. In Uzawa (1965), an individual’s productivity depends on how much
time she devotes to education. In Lucas (1988), human capital is the engine of growth and is
produced by a technology where the only input is human capital itself. Rebelo (1991)
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extended this model to add physical capital in the production of human capital. Becker et al.
(1990) presented a model where human capital is accumulated through parent’s home
teaching. Romer (1989) and Barro (1991) documented the importance of human capital in the
context of conditional convergence and persistent economic growth. Borjas (1992) presented
empirical evidence for human capital externalities by showing that the average level of human
capital of the previous generations positively affected the current generation’s productivity
level.

Such developments in endogenous growth theory have opened a new avenue of research
to study the influence of government spending on both consumption-saving decisions and,
through the education system, on human capital accumulation itself. King and Rebelo (1990),
Lucas (1990), Rebelo (1991) and Jones et al. (1993) are among the studies of endogenous
growth that analyze the consequences of distortionary taxation. While the studies mentioned
above employ an infinite-horizon framework, Blanchard (1985) carried the argument of debt
management into finite horizons and decisively influenced the stream of general-equilibrium
modelling.

Ni and Wang (1994) and Glomm and Ravikumar (1997), both under the assumption of
finite lifetimes, let public spending on education directly enter the production function of
human capital. Ni and Wang (1994) adopted the theoretical framework of Becker and Barro
(1988) and Becker et al. (1990), and examined the role of public expenditures on human
capital formation. Glomm and Ravikumar (1997), in turn, focused on the growth effects of
productive government spending and growth-maximizing level of taxation in a dynamic
general equilibrium model.

Azariadis and Drazen (1990) worked in a standard overlapping-generations (OLG)
framework, where they modelled identical individuals that make decisions about their
schooling. Davies and Whalley (1991) explored how explicit incorporation of human capital
affects dynamic general equilibrium analysis of the effects of taxes on capital formation and
welfare in a life-cycle growth model. Jones and Manuelli (1992) highlighted the role of
government as an income redistributor in an OLG framework that allows for persistent
growth. Likewise, Buiter and Kletzer (1991; 1995) used OLG models to present the
theoretical analysis of fiscal policies.
Heckman
et al. (1998; 1999) utilized a dynamic general equilibrium model with
heterogeneous agents, where they introduced skill formation and considered both the choice
of educational level and the investment in on-the-job training. Their framework extends the
analysis of Davies and Whalley (1991), who introduced human capital into the Auerbach-
Kotlikoff (1987) model, but assumed only one skill. Bräuninger and Vidal (2000) examined
interactions between education policy and growth by an OLG model with two types of
individuals – skilled and unskilled. Yeldan and Voyvoda (2000) utilized an OLG model of
endogenous growth and investigated the fiscal alternatives of financing public education in a
debt constrained economy framework.

Creedy and Gemmell (2005) utilized an endogenous growth model to examine the growth
effects of human capital investment achieved through publicly provided, compulsory
education. Lee (2005) developed an OLG model of career decisions, where an individual
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chooses between working in a white-collar occupation, working in a blue-collar occupation,
attending school or remaining at home. Gallipoli et al. (2006) examined the effects of
alternative policies on the distribution of education in a general equilibrium. They built a life-
cycle model with endogenous labour supply and education choices, allowing for agents’
heterogeneity in several dimensions, and for incomplete insurance markets. Sequeira and
Martins (2008) used an endogenous growth model with human capital and unemployment,
based on Mauro and Carmeci (2003), in order to study the effects of subsidies to education on
economic growth.


3.
Description of the General Equilibrium Model of the Slovenian Economy

The model SIDYN 2.0 is a dynamic endogenous-growth general equilibrium model of
the Slovenian economy, based on social accounting matrix (SAM) for the base year, and
parameter data on consumer preferences, production technologies, accumulation of human
capital and composition of total factor productivity (Verbič et al., 2009).

The model incorporates the following economic agents: (1) five households grouped into
quintiles according to income level; (2) twenty production sectors of both goods and services;
(3) investment sector; (4) national government; and (5) external sector. Each agent in the
economy supplies and demands a range of goods, services and factors of production at prices
defined by equilibrium on the corresponding markets. There are six types of production
factors in the model; country-level human capital differentiated by three skill (education)
levels, sector-specific physical capital, sector-specific R&D stock, and sector-specific human
capital stock. The output level of the aggregated commodity of each of the twenty sectors is
determined by an optimal combination of these production factors.

Both households and firms make their decisions under the assumption of an infinite
horizon with perfect foresight (rational forward-looking expectations). All prices in the model
are relative prices, which is the usual assumption of general equilibrium modelling. The inter-
temporal problem is formulated in discrete time for the purpose of numerical implementation.
To keep the derivation and calibration simple, all transactions are assumed to take place at the
end of each period, while decisions are made or planned at the beginning of each period.

Households maximize their inter-temporal utility given the budget constraint. They
decide how much time and money to invest into a particular type of human capital at each
period of time. The consumers’ decisions associated with spending of their money and time
are independent of each other. The use of money positively influences consumer utility via an
increase in consumption, whereas the use of time for education and work exerts a negative
influence upon the consumers’ utility level. Households do not invest in the sector-specific
stocks. The human capital stock owned by the households is freely traded on the labour
market and is mobile between the sectors. Sector-specific human capital is not mobile
between the sectors and thus not traded. Different income categories in the economy
correspond to different consumption patterns and governmental transfers.
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The firms choose investments into their physical capital, human capital and R&D stocks,
as well as labour inputs such as to maximize its present discounted value, i.e. the present
value of all dividend payments. Investments made by the firms are financed using the total
savings available in the economy. The stocks of sector-specific capital are accumulated over
time via the new investments made by firms and the government. Gross prices for final goods
are calculated as the sum of the producer price, transport and trade margins and various taxes
and subsidies, where the transport and trade margins are the spending on transport and trade
services, consumed in a certain proportion to the commodity itself.

Investments into physical capital are financed by the national investment agent with total
savings and are used to buy different capital goods. The split of the total physical capital
investment between the particular types of capital goods, such as machinery and buildings, is
done so as to maximise the utility of the investment agent, which decides on how much of
various capital goods are to be bought.

Economic growth is endogenously determined in the model by the development of
households’ human capital stock, stock of sector-specific human capital and R&D, used as
factors of production by the firms, as well as the development over time of the overall total
factor productivity (TFP). Sector-specific R&D investments have country-level spillover
effects via an increase of TFP for all sectors. The country-level TFP depends positively both
upon the total output of the R&D sector and the openness of the economy, represented by the
share of foreign trade in the GDP.

The public sector is represented by a national-level government, which collects a range of
taxes, receives its share of dividends, and pays subsidies and transfers to households and
firms, as well as transfers abroad. The revenues of the government consist of receipts from
personal income tax, corporate income tax, VAT, payroll tax, social contributions, and import
tariffs. The government subsidies support investment, production, intermediate consumption,
household consumption, and exporting. The government also consumes a range of goods and
services, and makes investments in national-level human capital and sector-specific R&D
stocks.

The external sector incorporates the representation of exports and imports, as well as
annual labour inflows from EU15, new member states and the rest of the world. Modelling of
the external sector is based on the assumption of a small open economy, meaning that the
prices of exports and imports are exogenously fixed in the model. Exports and imports are
defined by Slovenian output and income levels, as well as by the ratio between the prices of
domestic and exported goods and services, and elasticities of substitution between domestic
and foreign goods. Inflows of labour to Slovenia are defined by the changes in domestic real
after-tax wages and the elasticity of the labour supply, which is assumed to be higher for the
rest of the world than for the EU15 and the new member states.

The model is build within the general algebraic modelling system (GAMS), which has
become both most widely used programming language and most widespread computer
software for construction and solving large and complex general equilibrium models. Within
the GAMS framework, the dynamic general equilibrium model is written in Mathiesen’s
(1985) formulation of the Arrow-Debreu (1954) equilibrium model, i.e. as a mixed
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Document Outline

• WP-45-Miro.pdf
• WORKING PAPER 45_MIRO
• WP45_back_list of publications

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