By Brant Abbott, Giovanni Gallipoli, Costas Meghir and Giovanni L. Violante
This paper examines the equilibrium effects of alternative financial aid policies intended to promote college participation. We build an overlapping generations life cycle model with education, labor supply, and consumption/saving decisions. Cognitive and non-cognitive skills of children depend on the cognitive skills and education of parents, and affect education choice and labor market outcomes. Driven by both altruism and paternalism, parents make transfers to their children which can be used to fund education, supplementing grants, loans and the labor supply of the children themselves during college. The crowding out of parental transfers by government programs is sizable and thus cannot be ignored when designing policy. The current system of federal aid is valuable: removing either grants or loans would each reduce output by 2% and welfare by 3% in the long-run. An expansion of aid towards ability-tested grants would be markedly superior to either an expansion of student loans or a labor tax cut. This result is, in part, due to the complementarity between parental education and ability in the production of skills of future generations.
The best way to finance is an important issue and this paper shows that it matters. It also demonstrates that education should not be free, but its cost in the end should be tailored to the financial abilities of the parents. The worst outcome is if the government is not involved at all, and this even if student ability is correlated with parental wealth.